Impact of Capital Structure on Firm Performance: Evidence

from Manufacturing Sector SMEs in UK

Dr. D K Y Abeywardhana*
The purpose of this study is to investigate empirically the impact of capital
structure on firm performance. This study examined the impact of capital
structure on firm performance of manufacturing sector SMEs in UK for the
period of 1998-2008. The authors hypothesize that there is a negative
relationship between capital structure and firm performance. To examine the
association, the authors run a Pearson correlation and multiple regression
analysis. Results of this study reveals that there is a significant negative
relationship between leverage and firm performance (ROA, ROCE), strong
negative relationship between liquidity and firm performance and highly
significant positive relationship between size and the firm performance. This
study concluded that firms which perform well do not rely on debt capital and
they finance their operations from retained earnings and specially SMEs have
less access to external finance and face difficulties in borrowing funds. It is
recommended that firm should establish the point at which the weighted
average cost of capital is minimized and to maintain the optimal capital structure
and thereby maximize the shareholders wealth.

JEL Code: G32

Key words: Capital structure, firm performance, SMEs

1. Introduction

Choice of internal or external financing is one of the serious concerns of a firm. Capital
structure and its impact on firm value and performance is still a puzzle in corporate finance
theory and finance literature. Capital structure theories which are highly based on large
firms are failed to explain optimal mix of debt to equity. Capital structure choice is therefore
a crucial issue for both large and small firms. Well known theory of capital structure
irrelevance of Modigliani and Miller (MM) (1958) which is based on unrealistic
assumptions provided the foundation for the development of various theories, empirical
studies on capital structure, as this restrictive assumptions do not hold in the real world.

However finance theory and literature suggest that the optimal capital structure should be
employed but there is no consensus on how to achieve an optimal debt to equity ratio.
Further finance theory does support in understanding the impact of chosen capital
structure on value of the firm. Existence of optimum capital structure minimize the cost of
capital and ensure that the profitability of the firm is maximized. Managing the capital
structure properly is paramount important as it would affect the profitability and finally the
value of the firm. In efficient management of capital structure of the firm would lead to
financial distress and ultimately to bankruptcy. Gill et al.(2011) stressed that despite the
fact that there are many theories tried to explain the optimal capital structure researchers
in finance have never yet find a model to determine the optimal capital structure.

*
Department of Accountancy, University of Kelaniya, Sri Lanka. E mail: dilyapa@kln.ac.lk

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Enormous amount of researchers have been examined the capital structure choice on
performance in developed market and for large firms. In developed markets capital
markets are more efficient and suffers less from information asymmetry compared to other
emerging economies (Eldomiaty, 2007). Therefore the main focus of this study is to
investigate the impact of capital structure on financial performance of manufacturing
sector SMEs in UK which has not adequately research in financial literature.

2. Literature Review

Impact of capital structure on firm performance has been studied since 1952. Durand,
D,(1952) shed light on introducing theories on capital structure and their impact on value
of the firm. Since then it is received enormous attention in the financial literature among
scholars. Due to this inspiration a debate started among researchers and still it is
continuing like a puzzle without consensus. MM(1958) stated that the capital structure is
irrelevant and there is no optimal capital structure based on unrealistic assumptions.
According to Chaganti et al (1995) due to the assumption on rational economic behavior
and perfect market conditions of MM irrelevant theory, it has limited applicability to the
small firms. SMEs differ from the large firms in several aspects and different financing
decisions are applied (Heyman et al., 2008). SMEs have limited access to external finance
unlike larger firms and this is the fact that SMEs are motivated to depend more on the
self-generated funds or short term debt.

Studies on capital structure and firm performance are mainly based on the theory of
information asymmetry, signaling and agency cost. Following Jensen and Meckling (1976)
several other researchers (Fama and French, 1998; Gleason et al., 2000; Hadlock and
James, 2002) study the direct effect of leverage on firm performance based on the agency
theory and information asymmetry.

Ross (1977) came up with a model that describe the debt to equity ratio choice signals
the quality of the firm. This study explain that low quality firms face high cost to abuse the
market and signal about its high quality through incorporating more debt capital. Firms
with low debt capital are inclined to spend their free cash flow freely and finally generating
lower return. In contrast, firm with higher debt capital work very effectively as they are
committed to meet the interest payment of the debt holders and manage the rest of the
cash flow more effectively. Harris and Raviv (1988) explain higher leverage of the firm
as an antitakeover instrument. Higher the leverage of the firm means they bear a higher
risk and the firms with higher risk will be less likely to be acquired. For their own interest
managers of the firm manage higher amount of debt which is not consistent with the
agency theory.

Lots of empirical studies focus on impact of debt to equity mix on firm performance as
performance is significantly affected the capital structure of the firm. Titman and Wessels
(1988) from the US firms reported that a negative relationship between capital structure
and firm performance. Titman and Wessels (1988) argue that due to the cost and risk
associated with leverage small firms maintain less relationship with financial institutions
which make small firms less preferable clients and they are charged at high interest rates
while large firms are offered competitive interest rates. This is supported by Rajan and
Zingales (1995) and showed that profitability was negatively correlated with leverage.

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Confirming this idea Ozkan (2001) further explain that small firms are more sensitive to
economic downturns and face high chance of liquidation in situations of financial distress
as they have less resources available. As a result small firms use more short term debt
than larger firms. From a financial distress perspective as larger firms are more diversified
they are expected to go bankrupt less often than smaller ones (Pettit and Singer (1985),
so size must be positively related to leverage.

Investigating the effect of capital structure on profitability of listed firms on the Ghana stock
exchange Arbor (2005) reveal a significantly positive relationship between ratio of short
term debt to total assets and ROE. This suggests that profitable firms use more short
term debt to finance their business operations. Arbor (2007) examined the relationship
between capital structure and performance of SMEs in Ghana and South Africa during a
six year period 1998-2003. The empirical results indicate that short term debt is
significantly negatively related to the gross profit margin of both countries and long term
debt has significant positive relationship with gross profit margin of both countries. More
profitable firms should have lower leverage ratio than less profitable firms as they are able
to finance their investment opportunities with the retained earnings according to the
theory. Moreover the theory says that leverage has a negative effect on the firm
profitability. This idea is strengthen by Gleason et al (2000), Arbor (2005) and Arbor (2007)
more profitable firms tend to use earnings to pay debt and therefore they would have a
lower leverage than less profitable firms.

Majority of empirical studies in the past confirmed that capital structure has a negative
impact on profitability of the firm. Recently Omondi &Muturi (2013) presented that
leverage had a significant negative effect on financial performance of the firm and Umer
(2014) presented again that there is a negative correlation between capital structure and
profitability of the firm. But, Gill, et al.,(2011) showed that short-term debt; long-term debt;
and total debt had positive influence on profitability. Further Gill,et al., (2011) classified
the sample as service and manufacturing sector and found that the impact of short-term
debt and total debt on ROA was positive in both the service and manufacturing industries.

To sum up, it is proved from the previous discussion, some studies show a positive
relationship between capital structure and firm performance, others show a negative
relationship between capital structure and firm performance. It should be noted that
previous empirical findings have demonstrated that impact of capital structure on firm
performance is questionable. The present study was interested on the effect capital
structure on firm performance.

3. Methodology and Model

This section focus on the methodology of this study which will include research design,
nature and sources of data and analysis techniques. Explore most suitable research
methodology to achieve the research objective is the most important role in a research.
Therefore methodology of this study had been adopted to analyze the impact of capital
structure on firm performance.

3.1 Variable Selection

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The following predictions have summarized based on the trade-off theory, pecking order
theory, agency theory and the previous empirical studies to capture the impact of other
variables on profitability.

3.1.1 Performance

More profitable firms should have lower leverage ratio than less profitable firms as they
are able to finance their investment opportunities with the retained earnings. Leverage
has a negative effect on the firm profitability. This idea is strengthen by Gleason et al
(2000), Arbor (2005) and Arbor (2007) more profitable firms tend to use earnings to pay
debt and therefore they would have a lower leverage than less profitable firms.

In this study two profitability measures are used in which one indicate the firm
management use total assets to make profit and other indicates how well management
use the debt and equity capital to enhance the firm profitability. The profitability is
measured using the Return On Assets (ROA) (Abor,2007;Arcas and Bachiller,
2008;Goddard et al,2005) and return on capital employed (ROCE)(Krishnan and
Moyer,1997).

3.1.2 Capital Structure

In the literature the capital structure is measured in several methods. Three leverage
measures use in this study are total debt to total assets, long term debt to total assets or
short term debt to total assets and gearing ratio. Since long-term debt is issued more
rarely, it may measure a longer run relationship and may be more insensitive to
unexpected financial crises than is total debt (Krishnan and Moyer, 1997). Highly geared
firms tend to suffer as the proportion of gross profits dedicated to servicing debt increases
and the proportion accruing to shareholders shrinks accordingly (Goddard et al, 2005).
They found that the relationship between gearing and profitability is negative. According
to the agency cost hypothesis the higher debt or low equity to capital ratio reduces the
agency cost. There are several measures that can be used as a measure as leverage
such as debt to total assets is used as the leverage measure and debt to equity can also
be used as a measure of leverage. In this study leverage is measured by debt to equity
ratio.

3.1.3 Control Variables

Apart from the capital structure there are several other variables influence the
performance of the firm. Size of the firm, sales growth and liquidity ratio and capital
structure may be influenced by the firm performance. Firm size is measured by the
logarithm of the firm’s assets.

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3.2 Modelling

The model of the study is given below based on the variables choose in the previous
discussion.
Table 1- Variable definition and expected relationship
Variable Variable sign Sign Definition
Name
Performance ROA, ROCE Net profit to total assets, Earnings before
interest and tax to capital employed
Capital TD +/- Total debt to total assets
structure
Capital LTD - Long term debt to total assets
Structure
Capital STD +/- Short term debt to total assets
Structure
Capital STDTD + Short term debt to total debt
Structure
Size LOGSIZE + Natural log of total assets/natural log of
sales
Sales growth SALESGR + Percentage growth in annual sales
Liquidity LIQUIDITYR +/- Current assets to current liabilities

3.4 Sampling

Data was obtained from the FAME database. Selecting all firms from Manufacturing sector
reduce the problems associated with selecting a sample from specified industries. This
study selects all private limited firms in manufacturing sector SMEsi in the UK. We use
data from 1998-2008. Our analysis cover data from 1999-2008 as data for year 1998 are
used to calculate some variables for 1999. We dropped companies with zero sales. We
remove all outliers in the dataset by excluding observations that lie in the 1% tails of each
regression variable. Finally the selected sample consists of unbalanced panel of 224231
observations.

Descriptive statistics are given in Table 2

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 Table 2: Descriptive statistics

Mean Min Max SD N

ROA .0976 .0003 .3241 .1463 224231
ROCE .228 .0001 .6821 .9640 224231
LOGSALES 8.469 2.673 12.32 1.841 224231
LOGSIZE 5.991 4.56 18.97 3.680 224231
LIQUIDITYR 1.722 .0032 .962 4.302 224231
SALESGR .0564 -25.67 5.632 4.369 224231
TD 0.561 .001 .912 1.787 224231
STD 0.396 .016 .937 1.478 224231
LTD 0.164 000 .784 4.327 224231
Source: Author’s computation

Table 2 shows the descriptive statistics for the study. Capital structure proxies STD,
LTD and TD show mean of 39.6, 16.4 and 56.1 respectively for the manufacturing
sector SMEs which implies that SMEs in UK more rely on short term funds and do
not incorporate higher level of long term debt capital in the capital structure.
Moreover manufacturing sector SMEs performance is low for the selected period.
This is proved by the mean value of ROA and ROCE 9.76 and 22.8 respectively.

Descriptive statistics shows that 56% of total assets finance through debt, of
which 39.6% is short term debt showing the fact that Manufacturing sector SMEs in
UK are largely depend on the short term debt for financing their operations may be
due to the difficulty in accessing long term finance or young firms are resistance to
use external finance and rely on internally generated funds.

Table 3: Correlation Matrix

Variable ROA ROCE SALESGR LOGSIZE LIQUIDITYR TD STD LTD STDTD

ROA 1
ROCE 0.8101 1
SALESGR 0.0003 0.0003 1
LOGSIZE 0.1669 0.2254 -0.0065 1
LIQUIDITYR -0.0989 -0.0232 -0.0034 -0.0357 1
TD -0.0386 -0.0438 0.0013 0.1054 -0.1574 1

SDA 0.0696 0.0322 0.0001 0.0192 -0.2037 0.7515 1

LDA -0.0439 -0.1037 0.0017 0.1326 0.0287 0.5197 -0.1729 1
STDTD 0.0442 0.1082 -0.0032 -0.1209 -0.0632 -0.1833 0.3993 -0.7714 1

There does not appear to be high correlation between any of the explanatory variables
except the proxies of performance. Except the proxy for performance and capital structure
none of the variable is highly correlated. Therefore multicollinearity problem does not
exist.

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3.5 Empirical Model

We measure the effect of capital structure on profitability. The model for the
empirical investigation can be stated as follows.

ROAi,t = α0 + α1 LIQUIDITYRi,t +α2 LOGSIZE i,t + α3 TD i,t + α4SALESGR i,t + α5STDTD i,t + λt +ηi +ε i,t (1)
ROAi,t =α0 +α1 LIQUIDITYRi,t +α2 LOGSIZE i,t +α3 STD i,t +α3 LTD i,t +α4SALESGR i,t +α5STDTD i,t +λt +ηi +ε i,t (2)

Table 4: The impact of capital structure on firm performance ROA

MODEL 1 MODEL 2
Variables Coefficient Prob. Coefficient Prob.

C -0.6466 0.0000*** -0.7285 0.0000***

LIQUIDITYR -0.0123 0.0000*** -0.0171 0.0057**

LOGSIZE 0.0612 0.0000*** 0.0638 0.0000***

TD -0.0642 0.0000***

STD 0.0639 0.0085**

LTD -0.0651 0.0397**

STDTD 0.0041 0.0221** 0.0033 0.0471**

SALESGR 0.0078 0.1972 0.0072 0.2974

Adjusted R 2 0.845 0.774

*,**,*** indicates statistically significant at 10%, 5% and 1% respectively. As far as the diagnostic tests
are concerned we find no evidence of heteroskedasticity according to White test. Test for second-order
serial correlation in the first-differenced residuals, asymptotically distributed as N(0,1) under the null of
no serial correlation.

An alternative model for above equation can be written as follows with the proxy for the
dependent variable.

ROCE i,t = α0 + α1 LIQUIDITYRi,t + α2 LOGSIZEi,t + α3 TD i,t + α4SALESGR i,t + α5STDTD i,t +λt +ηi +ε i,t (3)
ROCE i,t = α0 + α1LIQUIDITYRi,t +α2LOGSIZEi,t +α3 STD i,t +α3 LTD i,t +α4SALESGR i,t + α5STDTD i,t +λt +ηi +ε i,t (4)

Variable definitions are given in the Table 1.

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 Table 5: The impact of capital structure on firm performance ROCE
MODEL 3 MODEL 4
Variables Coefficient Prob. Coefficient Prob.

C -3.6591 0.5721 -4.2831 0.0056**

LIQUIDITYR -0.0116 0.0000*** -0.0166 0.0061**

LOGSIZE 2.4857 0.0098** 8.5410 0.0040**

TD -0.0451 0.0056**

STD -0.0601 0.0074**

LTD -0.0561 0.0016**

STDTD -0.0043 0.0221** -0.0035 0.0315**

SALESGR 0.0080 0.1918 0.0073 0.4129

Adjusted R 2 0.439 0.642

*,**,*** indicates statistically significant at 10%, 5% and 1% respectively. As far as the diagnostic tests are
concerned we find no evidence of heteroskedasticity according to White test. Test for second-order serial
correlation in the first-differenced residuals, asymptotically distributed as N(0,1) under the null of no serial
correlation

Model estimation using panel data requires first to determine whether there is a correlation
between the unobservable heterogeneity of each firm and other control variables of the
model. We would obtain the consistent estimation by means of the within–group estimator,
if there is a correlation (fixed effects). If not,(random effect) the more efficient estimator
can be achieved by estimating the equation through Generalized Least Squares(GLS).
Using the Hausman(1978) test determined whether the effects are fixed or random under
the null hypothesisii.

The estimation is done using two stage least square fixed effect. The analysis is based
on variants of equations incorporating alternative proxies to measure performanceiii (ROA,
ROCE), leverage [TD (LTD + STD)]. As can be seen in the variable definition Table 1
there are two alternative measures for performance, two main alternative measures for
leverage of the firm. The result of the panel estimation is given in Table 4 and 5. Table 4
represent all the sample estimations for ROA and Table 5 represent all the sample
estimations for ROCE.

4. Findings

Performance which is measured by ROA and ROCE shows significant positive

association with firm size, so that large size seems to favor the generation of profitability.
This is same for the both measures of size. Increase in profitability with the size of the firm
support the earlier findings by Miller (1977), Fama and French (1998), Abor(2005), and
Abor(2007). Capital structure (TD) shows significant negative relationship with

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performance and this is contrary to MM (1958) signaling theory and with Gill, et al., (2011)
which explain a higher the debt ratio higher the performance of the firm. When firm
become more levered in the manufacturing sector firms are confronting with the default
risk of incorporation of debt. Liquidity ratio is significantly negative for all measures of
performance. Further this evidence that lack of liquidity has been an important cause of
business failure. Sales growth is insignificant and positively related with the performance
Sales growth which could be an indication of a firm’s business opportunities is an
important factor allowing firms to enjoy improved profitability. This is consistent with the
earlier findings of Arbor (2005, 2007). Short term debt to total debt is highly significant for
all the estimations and display a negative relationship with the performance of the firm
implying that short term debt is not profitable for the manufacturing sector SMEs.
Consistent with Fama and French (1998) and Arbor (2007) short term debt is significantly
positively correlated with the performance.

5. Summary and Conclusions

This study has examined the relationship between capital structure and the performance
of manufacturing sector SMEs in the UK for the period of 1998-2008. All the models tested
show a good explanatory poser power on the firm performance.

Positive but insignificant sales growth of sector indicates that the performance of the
SMEs in the manufacturing sector in the UK is not very much influenced by the internal
firm characteristics but might be more influenced by the external factors. Further it can be
concluded that in guiding investors regarding the choice of the firms operational
performance, fundamental analysis of the firm sales growth and efficiency have a little role
to play.

It is found that the capital structure of the manufacturing sector SMEs in UK does not
follow the MM (1958) theory of capital structure but this is consistent with the agency
theory as higher the leverage grater the agency cost of outside debt, and many other
studies that proved a negative relationship with leverage and firm performance. This
justified that firms which perform well do not rely on debt capital and they finance their
operations from retained earnings and specially SMEs have less access to external
finance and face difficulties in borrowing funds. It is recommended that firm should
establish the point at which the weighted average cost of capital is minimized and to
maintain the optimal capital structure and thereby maximize the shareholders wealth. The
size of the firm appears to be more important factor that determines the performance in
SMEs in the UK. In conclusion, manufacturing sector SMEs in UK are more interesting in
internal financing, other than debt finance.

This study with conclude with some important future research areas. It would be
suggested to include ownership structure to the analysis. That would be showing clearly,
especially for small firms that large part of the firm performance could be explained by
ownership structure. Further this study focused only the manufacturing sector and to get
a better understanding it can include other sectors in future research.

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i
European Union definition for SME is used.
ii
If the null hypothesis is rejected the effects are considered to be fixed. The model can be estimated by OLS.
Accepting null hypothesis would mean to have random effects and the model have to be estimated by GLS. More
efficient estimator of β we achieve in this way.
iii
This is extremely important as we can separate the fundamental earning power of the company from the effects
of management financing decision. For instance, firms with identical EBIT may have different net income depends
on the different level of debt finance they employ in the capital structure.

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