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.
BACKGROUND AND 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.