City University Research Journal

Volume 06 Number 01 January 2016 PP 70-80

IMPACT OF DEBT ON PROFITABILITY OF FIRMS;

EVIDENCE FROM NON-FINANCIAL SECTOR OF PAKISTAN
Hassan Jan Habib*, Faisal Khan** and Dr. Muhammad Imran Wazir**

ABSTRACT
This study focuseson expanding the existing empirical knowledge on the impact of debt
on profitability of companies. Different sets of variables havebeen used to investigate
the relationship between debt and profitability of firms with empirical evidence from the
non-financial sector of Pakistan; using panel data of 10 years, ranging between 2003-
2012. Return on Assets is used as the profitability measure and is the dependent
variable, whereas; Short Term Debt to Asset, Long Term Debt to Asset, Total Debt to
Asset are used as independent variables, while Size, Sales Growth, and Growth
Opportunity are used as control variables. Random effect regression analysis is used to
find out the impact of debt on profitability. Results indicate a significant but negative
relationship between short term debt, long term debt, total debt, and return on assets.

Keywords:

INTRODUCTION
1.1. Background of the Study:
In this modern corporate era, every corporation tries to survive the tough competition.
Capital structure decision making has become one of the most difficult tasks for the fate
of a firm. Capital structure decision plays a vitalrolefor any business organization which
aims at maximizing returns and makes it able to compete in its competitive environment
(Abor, 2005). Risk taking is inevitable for managers in order to avoid major threats to
the firm (Jensen and Meckling,1976). Thus, managers must take into account the causal
relationship, find a special solution and make a decision which follows a systematic
approach; otherwise it can bring the company to the brink of destruction.
For decades, after Modigliani and Miller(1958)'s theory of capital structure, optimal
capital structure remained the center of attention for many researchers. Optimal capital
structure is critical to its ability to achieve near-and long-term growth objectives. It
ensures that companies should maintain an adequate level of capital in both good and
bad times. Firms preferably raise finance by utilizing their internal sources whenever
possible, rather than outsourcing the funds from any other source like bank loans or
issuing bonds. Whereas; equity financing is considered when there is no other choice
because issuing new shares will bring more partners/shareholders into the company and
resulting in diluting the existing shareholding. “The use of debt in capital structure of the
firm leads to agency costs. Agency costs arise as a result of the relationships between
shareholders and managers, and those between debt-holders and shareholders” (Jensen
and Meckling, 1976).
*Hassan Jan Habib, Management Training Officer, Bank of Khyber, Pakistan
**Faisal Khan, Lecturer, Quaid-e-Azam College of Commerce, University of Peshawar
***Dr. Muhammad Imran Wazir, Assistant Professor, Institute of Management Sciences,
Peshawar
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The relationship between debt and profitability of firms has been a center of attention for
many researchers over decades, however, there is difference of opinion between
different researchers about the role of debt, some researchers found negative (Abor
2005), some found positive (Margrates and Psillaki 2010), while some found mixed
results of debt on profitability (Weill 2008). This difference of opinion is due to many
reasons including different types of variables, sample size (countries, industries/sectors,
firms and periods), and methodologies.
This study focuses on finding the impact of debt on the profitability of firms of Pakistan.
Mostly, the reported studies have taken a single sector or a company over a period of
time, however; there are a handful studies that had focused on financial or non-financial
sector as a whole. This study while using different set of variables investigates the role
of debt in profitability of firms with empirical evidence from the non-financial sector of
Pakistan. A panel data of companies listed on Karachi stock exchange (KSE) for the
period 10 years, ranging from 2003-2012. This study will provide a comprehensive
view to finance managers about the relationship between debt and profitability.

LITERATURE REVIEW
2.1. Theoretical background:
Modigliani and Miller's (1958) work on capital structure by was the beginning of new
era in Corporate Finance. A theory of capital structure known as MM theory/capital
structure irrelevance theory (1958), which states that “under no taxes and transaction
costs, the cost of capital and the value of the firm do not change with a change in
leverage” Modigliani and Miller's (1958). Lately, a new proof was presented by
Modigliani and Miller (1963) stating that “cost of capital effect capital structure, and
therefore effect the value of the firm by ignoring the unrealistic assumptions and
considering that there exist taxes; which indicate that borrowing gives tax advantage,
whereas the interest deducted from the tax will result tax shields, while reducing the cost
of borrowing and maximizing the firm performance” (Miller, 1977).
There are four different theories about capital structure which reflect the influence of
debt on corporate profitability, namely: Pecking order theory, the agency costs theory,
tradeoff theory, and signaling theory.
Pecking order theory states that “firms prefer using internal sources of financing first,
then debt and finally external equity obtained through shares” [Shyam-Sunder and
Myers (1999)].
“Agency costs arise as a result of the relationships between shareholders and managers,
and those between debt-holders and shareholders” (Jensen and Meckling,
1976).According to the agency costs theory, there are both positive as well as negative
effects of debt on profitability. In case of agency costs of equity between shareholders
and managers, it has positive effect. Whereas; agency costs of debt between
shareholders and creditors have negative effect on profitability.
The trade-off theory deals with the idea of choosing capital structure, i.e. what
proportion of debt and equity should a company choose. According to Trade-off theory,
debt financing can give tax benefit, but on the other hand it also has some costs like
bankruptcy cost and financial distress cost etc.
Signaling theory states that, “the debt; in the presence of asymmetric information,
should be correlated positively to profitability”(Kebewar, 2013).

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2.2. Empirical review:

Modigliani and Miller's work had been inspiration for many researchers despite of its
unrealistic assumption; it has attracted the attention of many researchers. Researchers
are trying to analyze and find the existence of an optimal capital structure. Optimum
capital structure can be defined as “the capital structure at which the weighted average
cost of capital is minimum and thereby maximum value of the firm.” The difference of
opinion between researchers can be observed about the effect of debt on profitability.
Some researchers found positive impact of debt on profitability, some found negative,
while some had both negative as well as positive results.

2.2.1. Positive relationship between debt and profitability:

Wippern (1966) while using debt to equity ratio and earning to market ratiostudied some
industries and found that there is a positive relation between debt and profitability.
Abor (2005) study turned out to be the same. He studied some of the Ghana stock
exchange listed firms and found that there is a positive relationship between short-term
debt to total assets and Return on Equity. Gill, et al., (2011) tried to expend Abor's (2005)
study by investigating a sample of 272 service and manufacturing firms listed on New
York. His results showed similarity to Abor's research.
Margrates and Psillaki (2010) also found a positive impact, and proved that debt ratio
positively affect the performance of a firm.
Holz (2002), Sarkar and Zapatero (2003), Dessi and Robertson (2003), Baum et al.
(2006), and many other researchers also found a positive influence.
2.2.2. Negative relationship between debt and profitability
In contrary to positive relation; negative effect of debt on profitability was also
confirmed. Mendell, (2006) studied20 firms of the forest industry. His results reflected
that the existence of a negative relationship between debt and profitability.
Mohammad and Jaafer (2012) studied 39Amman Stock Exchange based companies and
analyzed the role of debt in profitably. His results indicated significant but negative
relationship between short term debt, long term debt, total debt, and return on equity,.
Kebewar (2013) performed a studyonFrench companies. His study was based on2325
trade sector companiesover a period of 8 years between 1999 to 2006 foundthat debt
have negative affect on profitability. Anandasayanan&Subramaniam(2013) studied
manufacturing firms listed on Colombo stock Exchange and found significantly
negative relation between debt and profitability.
Wali, Fatima, and Mehboob(2012) studied seventeen (17) textile companies listed on
KSE using longitudinal data from 2003 to 2007 and found that the short term debts
negatively affects profitability.
Krishnan and Moyer(1997), Mathur(2000), Goddard et al. (2005), Zeitun and Tian
(2007), King and Santor(2008), Kajola(2010), and many other researchers also found
negative relationship between debt and profitability.

2.2.3. Mixed results of debt and profitability:

Besides positive and negative impact of debt on profitability; mixed results were also
found. Hurdle (1973) using different regression models found different results.
According to results, positive results were reported using OrdinayLeast Square (OLS)
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method, while two stage least squares (2SLS) indicated a negative effect on
profitability. McConnell and Servaes(1995) and Agarwal and Zhao(2007) found that
firm with high growth debt has negative effect on profitability, while firms with low
growth effect positively.
Weill (2008) studied different European countries to find the effect of leverage on firm
performance. His results indicated that debt positively affectsprofitability in countries
like Spain and Italy, whereas, Belgium, France, Germany, and Norway showed contrary
results.While Portugal gave insignificant results.
Cheng,Liu and Chien (2010) investigated 650 Chinese firms and the results showed
positive relationship when the debt ratio between(53.97%-70.48%),on the other hand,
negative relationship was found when the debt ratio exceeded 70.48%.
Dwilaksono.H, (2010) investigated the effect of short and long term debt to profitability
of Mining industry Companies listed in Indonesia Stock Exchange and 2003-2007 and
found the existence of negative but significant relationship between Long Term Debt
and profitability.
Mesquita and Lara (2003), Agarwal and Zhao (2007), Li Meng ,Wang and Zhou(2008)
found mixed results in their studies.

DATA DESCRIPTION AND METHODOLOGY

3.1.Sample Size:
Entire non-financial sector of Pakistan was selected for this study, but due to
unavailability of data of few years in some companies, these companies were eliminated
from the analysis. After eliminating such companies, the data consist of 340 firms listed
on the KSE for the period 2003–2012 has been used for analysis.

3.2.Variables:
3.2.1. Return on Asset:
It is used as a Dependent variable. ROA is an indicator which shows the ability of a
company to generate profitable against its total assets. It reflects the efficiency of
management in utilizing its assets to generate earnings. It can be calculated as:

3.2.2. Short-term debt to asset:

Shows the portion of company's assets which are financed with debt payable within one
year. Mathematically it can be represented as:

3.2.3. Long-term debt to asset:

Shows the percentage of assets financed with debt which ispayable after more than one
year. It includes bonds and long-term loans. Mathematically:

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3.2.4. Total debt to asset:

Total debt is the mix ofshort-term liabilities and long-term liabilities. In balance sheet it
is represented as "Total Liabilities”; and can be mathematically expressed as:

3.2.5. Size:
It is used as a control variable. Size is calculated by taking the log of sales.

3.2.6. Sales Growth:

Sales growth is the change in sales from one year to another. It is used as a control
variable. It can be calculated as:

3.2.7. Growth opportunities:

Growth opportunity is calculated by the change in total assets from one year to another.
It is used as a control variable

Table 1. Variables

3.3. Hypothesis:
H1 = There is no relationship between STDA and ROA.
H2 =There is no relationship between LTDA and ROA.
H3 = There is no relationship between TDA and ROA.

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3.4. Theoretical Framework:

3.5. Model Specification:

Random effect regression model has been used to find the relationship between
dependent and independent variables. Model used in this study is similar to the model
used by Abor (2005).

Where,
is dependent variable, and i=entity, and t=time
is independent variable
is the co-efficient for that variable
is the intercept for each entity
is the error term

The following regression models have been used in this study:

Whereas:
ROA is net income divided by total assets of firm i in time t;
is short-term debt divided by the total assets of firm i in time t;
is long-term debt divided by the total assets of firm i in time t;
is total debt divided by the total assets of firm i in time t;
is the log of sales for firm i in time t;
is sales growth of firm i in time t; and
is change in total assets
e is the error term

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RESULTS ANALYSIS
4.1. Diagnostic Regression:
Before interpreting the results, various diagnostic tests were run on data.

4.1.1. Data Normality Test:

For regression, it is necessary that the data should be normal. Therefore, to remove
outliers from given set of data, data normality test was run. Few outliers were found and
then removed in order to normalize the data.

4.1.2. Hausman Fixed and Random Effect Test:

The test evaluates whether to accept fixed effect or random effect regression model. If
the P-value of this test is less than 0.05, then we should accept fixed effect regression
model or if it is greater than 0.05, then should follow random effect regression model. In
this study, the P-value was greater than 0.05, therefore, random effect regression model
is used.

4.2. Random Effect Regression:

This section exhibit the results drawn from the Regression Equations used in the
analysis. The results are separately discussed so that comparison can be made between
different financing options.

4.2.1. Equation 1:
Table (1) indicates that there is a significant but negative relationship between the
STDA and ROA. R-square value indicates 24.82% variation in dependent variable has
been explained by variation in independent variables. The results also show that control
variables play role inincreasing the profitability. A conclusion can be drawn, that short-
term debt is morecostly; therefore increasing in short-term debt in capital structure will
result in a decrease in profitability. Therefore, the hypothesis H1 i.e. there is no
significant relationship between STDA and ROA; is rejected.
Table 2. Relationship between ROA and STDA

4.2.3. Equation 3:
The P-value in table (3) clearly indicates the existence of a significant relationship
between TDA and ROA, but the relationship is negative. It shows that increasing the
proportion of total debt will results in lowering the profitability of a firm. R-square value
indicates 24.19% variation in dependent variable has been explained by variation in
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independent variables. This result concur with the pecking order theory i.e. “firms
prefer internal funds over the outside financing options”.
Hence, the hypothesis H3 i.e. there is no significant relationship between TDA and
ROA; is rejected.
Table 4. Relationship between ROA and TDA

CONCLUSION AND RECOMMENDATIONS

5.1. Conclusion:
Capital structure decision making is vital for the success of a company. Equity and debts
are the two main sources of finance for a company. The choice of right proportion of
debt and equity in capital structure will help in increasing the company's profitability.
Debt on one hand allows companies to do things that they would not be able to do
otherwise, but on the other hand it also increases overall risk of the company. There is
slight difference of opinion about the role of debt in profitability. The literature reveals
different results under different circumstances.
This study reveals a significant but negative relationship between debt and profitability,
thus, the higher the debt, the lower the profitability. It concur with Pecking order theory.
Debt appears to be more costly due to certain reasons, therefore increasing the
proportion of debt in capital structure will results in low profitability. It can be observed
that profitability is positively correlated with the control variables. The results of this
study concur with Mohammad and Jaafer (2012), and Kebewar (2013).

5.2. Recommendations:
Results indicate a negative relationship between debt and profitability, i.e. increasing
debt in capital structure will decrease profitability. Therefore, companies should prefer
internal financing or other sources of financing on debt financing.
The time period of this study includes the years (2007-08) of global financial crises,
which affected companies' performance over the time. So, there is still room for
improvement, therefore, researchers should consider increasing span of study to make
the results more reliable.

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