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Relationship between Capital Structure and Profitability

Info: 5118 words (20 pages) Example Literature Review
Published: 6th Dec 2019

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Tagged: Finance


Main purpose of financial decision making is to “increase the value of shareholder’s of firm” and these financial decisions can be very tricky sometimes. One basic question “proportion of debt to equity?” and there could be hundreds of options but to decide which option is best in firm’s particular circumstances. Use of more proportion of Debt in capital structure can be effective as it is less costly then equity but it also has some limitations and in the case of bank it has some regulatory restrictions. After the certain limit it will affect company’s leverage (traditional theory of Capital Structure). Financially troubled or risky companies could face severe consequences as they normally have higher interest rates on debt. So there should be a balanced proportion of securities mix in firm’s capital structure. Capital structure affects leverage and consequently profitability of firm. Firms with less earnings and high leverage are more exposed to risk and less attractive for investors. Most of these statements are true for banks also but capital structure of banks is a bit different from firm’s perspective. So far there is no clear understanding about combination of financing options and this is because of regulations government/ regulatory body imposed on these banks. Banks have to adjust theirs source of financing according to the regulations. All the banks are regulated by the State Bank and rules of SBP are same for all the banks but still these banks have different levels of profitability. Research paper aims to observe Banking sector of Pakistan (population) during this research because this sector has a major impact on the economy of Pakistan. Objective of this research is to investigate the relationship between capital structure and profitability of Banks regulated by the State Bank of Pakistan because one of the main factors that effect profitability is capital structure decision. For this research paper sample of 20 banks is taken and their 5 years financial data i.e. 2004-2008.

Idea for this paper is taken from a research article written by Joshua Abor (2005). The variables used by Prof. J. Abor in that study are different from those used for this paper. These variables are taken after going through the literature. Gearing ratio and Equity Multiplier are taken as an independent variable and dependent variables are Return on Equity (ROE), Return on Assets (ROA), Net Interest Margin (NIM), Efficiency ratio, Burden ratio, Earning Base and Spread ratio. For better analytical results, Size (log of Total Assets) is used as control variable.

This study has certain limitations like full access to the data related to this research is a problem, sample selected can be constraint to the research, data is gathered through published financial reports and data shown in the reports might or might not represent the actual picture. This research is helpful for further studies in a way that now one doesn’t need to find the profitability of banks in Pakistan and one can focus on certain broad areas like profitability interrelationship of local and multinational banks, determinants of capital structure of the banks, liquidity position and so on.


Capital is the engine of the economy and the financial information is the oil that keeps the engine running smoothly (R.S Raghavan) [1] . Capital in the dictionary of financial institution like banks is the Capital Funds, which are the total Owned Funds available to the Institution for a reasonably long time. ICCMCS [i] (2004) divided this capital into Core capital (basic equity) and Supplementary capital [2] and classified in Tier I, Tier II and Tier III Capital.

Tier 1 capital is the core measure of a bank’s financial strength composed of equity capital, mainly common stock and disclosed reserves like retained earnings. [3] 

Tier II capital is used to measure the financial strength of a bank and is the second most reliable form of financial capital [4] . It includes Revaluation of assets (a reserve created when a company has increase in the value of asset and that increase is brought into the accounts), Undisclosed reserves (Reserves that are not burdened to any liabilities), General Provision (shelter against those losses whose actual impact is not known), Hybrid instruments which are the capital instruments having the debt & equity characters and Subordinated debts. [5] 

Tier III capital is used to support market risk, commodities risk and foreign currency risk. Tier III capital debts may include a greater number of subordinated issues, undisclosed reserves and general loss reserves compared to tier II capital [6] .

Banks play a leading role in mobilizing savings, allocating capital, overseeing investment decisions of corporate managers, and providing risk management vehicles as mentioned by Asli Demirgiu-Kunt, Harry HuizIi (2000). [7] 

Capital structure is the combination of a firm’s debt (long-term debt and short-term debt) and equity (common equity and preferred equity). So the Capital structure is the firm’s various sources of funds used to finance its overall operations and growth. Debt is in the form of bond issues or long-term notes payable, while equity consists of common stock, preferred stock, or retained earnings. Joshua Kennon [8] stated advantages and disadvantages of each financing option and management always tries to find out the best combination to finance their capital.

According to Eugene F. Brigham [9] there is an optimal capital structure which is the best combination of equity and debt financing. On this level of optimization, cost of the capital is minimum and value of the firm is maximum. J.Abor (2005) believed that there is no universal theory of debt-equity choice, different choices are used in different situations.

The concept of capital structure is very important for any firm. It not only helps in determining the return a company earns for its shareholders and also shows whether or not a firm survives in a recession or depression (Joshua Kennon).

Equity financing is one of the financing options, and is composed of funds that are raised by the business itself. This financing can be raised by the owners of the firm or by adding more peoples in the ownership i.e. issuing the shares of the company. There is certain amount paid against these share and the shareholders get dividend against those shares or against that money they have invested in the company. It depends on the company’s policy that how much capital they need and how much capital should be raised through shares. Mostly those companies use equity financing which have high growth rate because they can give high return to the investors and can be attractive for the investors. Many consider equity capital is the expensive type of capital because its “cost” is the return the firm must earn to attract investment (Joshua Kennon)

Debt financing, second choice of financing means borrowing money to run the business. The amount of debt that a firm uses to finance its assets is also called leverage. Debt Financing constitutes of Long term debt and Short term Debt based on the type of money one borrows. Interest rates for long term debt and short term are different and vary from situation to situation and firm to firm.

Long term debt refers to the money one borrows for financing the assets which can be used by the firm for longer periods. e.g.; Purchase of Assets, machinery, land etc. Long term debt is commonly called Long term loans or long term liability of the firm. The scheduled payment of long term loan is usually extended for more then 1 year. In the case of Banks their sub-ordinate loans, saving deposits and fixed deposits are long term in nature because they are mostly for more then one year depending on the nature.

Short term debt is the money that is used for daily basis business operations like purchasing of inventory or paying the wages. Short term financing is referred to operating loan or short term loan and its scheduled payment takes place within the year. Usually short term loan is taken for some days or 3-6 months. Banks usually take loan from other financial institutions for very short period just to fulfill their daily requirement.

There are different theories of capital structure, traditional theory of Capital Structure says that use of more proportion of Debt in capital structure can be effective as it is less costly then equity but it also has some limitations. After the certain limit it will affect company’s leverage. [10] Trade off theory [11] states that debt financing has an advantage because of tax benefits, and this is choice of company in which combination debt: equity financing is used to balance the cost and benefits. Stewart C. Myers and Nicolas Majluf (1984) [12] states that companies prioritize their sources of financing (from internal financing to equity) according to the Principle of least effort, According to them, internal funds are used first, and when there are no more benefits from internal funding debt should be issued and as a last option equity should be issued. (Pecking Order Theory)

In the light of these theories and literature there are advantages and disadvantages for debt as well as equity financing [13] . Benefits attached with debt financing are, company can retain maximum control over their business and the interest on debt financing is tax deductible which means that debt financing has tax benefit.

There are also some disadvantages for debt financing. Too much debt can cause problems if company begin to rely on it and do not have the revenue to pay it back. Also too much debt will make the company unattractive to investors because of leverage problem and will charge more while issuing the debt.

While talking about equity financing, this appears to be “easy money” because it involves no debt and there is no need to worry about repayment in the traditional way.  As long as business makes a profit, the lenders will be repaid and with the help of investors, business becomes more credible and may win new attention from the lenders’ networks. Disadvantage is that company can lose its complete control and autonomy, now investors will also have part in decision making. Too much equity may indicate to potential funders that company is willing to take the necessary personal risks, which could signify a lack of belief in your own business venture.

Banks and financial institutions are specialized businesses whose capital structure is affected by different factors specific to the banking industry, such as government regulation and access to a federal safety net. If government lowers the discount rate then according to tradeoff theory, banks will try to get loan from central bank and their debt portion will rise, so to handle this situation central bank enforces banks to hold more capital to balance the position. If central bank makes change in regulations like decrease in SLR and CRR then more money will be available for lending and it will affect capital structure and profitability accordingly. Capital structure theories help in explaining the choices banks made to raise capital during the financial crisis. As pecking order theory suggests, banks should choose to issue debt before equity to reduce the undervaluation problem, if they have private information about their assets. But, during the financial crisis, the asymmetry information about bank’s asset portfolio becomes so severe that equity could be issued only at a substantial discount. At that time, issuing preferred stock might be good choice because at that time issuing common stock at discount would transfer the wealth from existing shareholders to new one, and issuing debt will increase the probability of default. Unlike debt service payments, preferred stock dividends can be poised without triggering bankruptcy. Here investors can demand higher rate of return because preferred stocks dividend is given after debt payments. In order to lower dividends, banks can issue convertible preferred stock, which gives holders the right to convert preferred shares into common stock at a pre specified price.

To raise capital, from any source there is some cost associate with it which helps in determining which choice should be used (through issuing stock, borrowing, or a mix of the two). Cost of raising money can be reduced with the best combination of equity and debt financing.

In the case of banks there are some regulations from the central bank related to the minimum requirement of holding the capital. Despite of the cost of holding that capital banks have to fulfill that requirement.

As Mishkin (2000) stated that most of the bank managers want to hold less capital than is required by the regulatory bank, because of the high costs of holding capital.

To investigate the relationship between Capital Structure and Profitability of Banks there are many variables that can be used. Joshua Abor [14] , Chin and Ai Fu [15] used Gearing ratio and Equity multiplier to measure capital structure. Asli Demirgiu-Kunt and Harry HuizIi took Return on Asset and Net Interest Margin to measure the profitability of banks. Chin, Ai Fu (1997) while finding the relationship between capital structure and profitability focused on Debt to equity, Return on Investment. During the study of financial ratios of major commercial banks, conducted in Oman, Dr. Y. Sree Rama Murthy (2003) focused on Return on Equity, Return on Assets, Net Interest Margin and burden ratio. These ratios are linked with the financing decision of the Bank i.e. Capital Structure

According to P. P. Athanasoglou, S. N. Brissimis and M. D. Delis (2005) [16] expanses of the bank are very important factor to measure profitability.

Choice of capital structure influence Return on Assets because of the treatment of interest in calculating taxes and a company with a high debt pays less taxes (due to higher interest expense) compared to a company with no debt [17] .

ROA also resolves a major shortcoming of return on equity (ROE). ROE is the most widely used profitability metric but it doesn’t tell us if a company has excessive debt or is using debt to drive returns. This information can be gathered through ROA, in a sense that denominator in ROA is total assets which also includes liabilities like debt (Assets = liabilities + shareholder equity). So lower the debt, higher the ROA [18] .

This equation also shows that if a company carried no debt, their ROE and ROA would also be the same because its shareholders’ equity and its total assets would be the same which means that.

But if that company takes debt, ROE would rise above ROA. Reason is because shareholder’s equity is assets minus liabilities. By taking on debt, a company increases its assets because of the cash that comes in but at the same time equity shrinks, and since equity is the ROE’s denominator, ROE will get a boost [19] .

This measure is influenced by capital structure decision. Profitability, productivity, and capital structure [20] are three main drivers of ROE. The finance department at DuPont identified these components as profit margins, asset turnover, and financial leverage. So if there is any change occurs in the proportion of debt and equity, this measure will be affected because according to DuPont equation ROE is linked with Equity Multiplier and Capital Structure. Denominator of ROE is Shareholder’s equity and if company raises debt the portion of equity will shrink and if that portion shrinks this will results in high ROE.

Net Interest Margin is used to measure the performance which analyzes how successful a firm’s investment decisions are compared to its debt situations. This is in relation with issuing debt, debt is issued for financing purpose and to balance the net affect that debt is used to generate some returns. Higher the portion of debt related to equity will affect this measure. A negative value shows that the firm did not make an optimal decision, because interest expenses were greater than the amount of returns generated by investments. [21] 

Efficiency Ratio is a ratio that is typically applied to banks, in simple terms is defined as expenses as a percentage of revenue (expenses / revenue), with a few variations. Banks are unique businesses their most of the income comes from interest and they also have interest expanse. A lower percentage is good as it shows expenses are low and earnings are high. [22] 

A bank with a low burden ratio is better. An increasing trend would show lack of burden bearing capacity, this is in relation with total assets and these assets are financed by long term debt which comes from issuing debt. [23] This measure is compared with net interest income which helps in understanding that how well assets and are used to generate returns.

Interest spread is very similar to interest margin. If a bank’s lending is exactly equal to its borrowings (i.e. deposits plus other borrowing) the two numbers would be identical. In reality, bank also has its shareholder’s funds available to lend, but at the same time its lending is controlled by reserve requirements. [24] Changes in the spread are an indicator of profitability as the spread is where a bank makes its money.

Nicos Michealas, Francis Chittenden and Panikkos Poutziouris [25] (1998) consider diverse non-financial and behavioral factors which influence capital structure decisions. They used exploratory method of conducting interviews for their study. They found that there are some factors like need for control, experience, mind perception and social norms etc made certain belief about debt and this belief make their attitude toward using of debt proportion in their capital structure. There are also large numbers of small firm owners who prefer to rely on internal generated funds rather than raising external finance.

John C. Groth and Ronald C. Anderson [26] (1997) defined capital structure and examined its influence on the cost of capital and the value of a company. There is no equation exist to determine the optimal capital structure for firm. Proper use of debt and equity in capital structure lowers the weighted cost of capital and that low weighted cost of capital helps in increasing the value of the firm.

Arun Upneja and Michael C. Dalbor [27] (2001) examined the capital structure decisions of restaurant firms in USA. Pecking-order theory and position of the firm in the financial growth cycle are the bases for their study. Their result showed that both pecking-order and financial growth cycle influence capital structure decision of the restaurant firms. They found some separate factors which influence long term and short term debt decisions of the restaurant firms

Mohammed Amidu [28] (2007) investigates factors involved in the determination of capital structure of banks in Ghana. The variables that are covered in this research article are profitability, growth, tax, asset structure, risk and size. This study highlighted the links between long and short forms of debt while making capital structure decisions. It is found that long-term debt structure is positively and statistically related to operating assets. While short-term debt and leverage move in same direction. The study suggests that profitability, asset structure, growth, corporate tax and bank size are important variables to influence banks’ capital structure.

Rajeswararao Chaganti and Fariborz Damanpour [29] (Oct., 1991) tried to answer two main questions. One what are the relationships between outside institutional shareholdings, on the one hand, and a firm’s capital structure and performance? And secondly does the size of stockholdings by corporate executives, family owners, and insider-institutions modify those relationships? They have collected data from 40 pairs of manufacturing firms and found that the size of outside institutional stockholdings has a significant effect on the firm’s capital structure and family and inside institutional owners’ shareholdings moderate the relationship between outside institutional shareholdings and capital structure.

Mohamad Khan Bin Raji Jamal [30] (1994) examined the influence of capital structure, particularly in the presence of market imperfections on firm’s profitability. The effect of corporate taxes, interest expense, debt level and equity size was also analyzed by him. The findings of this research paper are that higher debt level results in a lower profitability and higher profitability associates positively with taxation expense but negatively with interest expense.

F. Voulgaris, D. Asteriou and G. Giomirgianakis [31] (2004) investigate the determinants of capital structure of Large Size Enterprises (LSEs) in the Greek manufacturing sector. The findings show that asset utilization, total assets growth and net profitability have a major impact on the capital structure of LSEs. Greek LSEs will face higher debt levels in the future that will arise mainly from higher short-term debt ratios. The ratios such as asset profitability, asset structure, return on equity, inventory turnover and liquidity which came out as significant determinants of capital structure in other empirical studies did not prove to be significant in this study.

Guorong Jiang, Nancy Tang, Eve Law and Angela Sze [32] (2003) have tried to answer the question of “whether both bank-specific as well as macroeconomic factors are important determinants in the profitability of banks” and “A profitable banking sector is better to resist against negative shocks and contribute to the stability of the financial system or not”. They conclusion of their study is that a profitable banking sector can better resist against negative shocks and can help in stable financial system. In terms of bank-specific factors, operational efficiency is the most important factor in explaining differences in profitability and macroeconomic developments have also an important effect on bank’s profitability.

Chiang Yat Hung, Chan Ping Chuen Albert, Hui Chi Man Eddie [33] (2002) shows the inter-relationship between cost of capital, capital structure and profitability among property developers and contractors in Hong Kong. The data for this research paper was collected from Datastream, an electronic financial database. The analysis of this paper shows that gearing is generally higher among contractors than developers and capital gearing is positively related with asset but negatively with profit margins.

Panayiotis P. Athanasoglou, Sophocles N. Brissimis, Matthaios D. Delis [34] (2005) found the determinants of profitability in banking sector. According to their study size of the bank, financial strength, ownership status, operating expanse, cost decisions of bank’s management are the major factors influencing the profitability of Banks.


This study sampled 20 banks (list of banks will be provided on request), mostly from private sector. This study is based on quantitative data analysis. Financial data was collected from annual reports of the banks. The proposed period is from 2004 to 2008. Independent variable is Capital structure which is analyzed through gearing ratio [ii] and equity multiplier [iii] . Gearing ratio and equity multiplier are used to investigate the relationship of long term liabilities [iv] and total assets with shareholder’s equity. Profitability is dependent variable which is measured through commonly used Return on Assets [v] and Return on Equity [vi] . Expanses of the bank are very important factor to measure profitability according to Panayiotis P. Athanasoglou (2005). Net Interest Margin [vii] , Efficiency ratio [viii] , burden ratio [ix] , spread ratio [x] are taken for analysis which are linked with bank expanses, some variables are used in relation with earning assets [xi] and interest bearing liabilities [xii] . Along with these variables earning base [xiii] is also used for measuring profitability. Size is taken as control variable in this research.

In the first phase financial data is collected from the annual reports of banks and is analyzed through above mentioned ratios in the second phase. Collected data was in the form of panel data which allows the use of panel data methodology. Panel data refers to two-dimension data containing observations on multiple phenomena observed over multiple time periods. This dataset have data on i cases, over t time periods, for a total of i × t observations. Third phase is comprised of analysis of this panel data with the help of regression tool.

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