Impact of Leverage Ratio on Profitability

8/9/2019 Impact of Leverage Ratio on Profitability

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Impact of Leverage Ratio on Profitability(Case of Pakistani Companies)

Abstract:

Our study aim to reveal the relationship between leverage and profitability and hence to drawthe conclusion that levered firm have advantage over non-levered firm. We have taken data of

five year i.e. from 2005-2009. ample consists of eleven companies which are chosen from ! " #0 $nde%. &s ! " #0 $nde% consists of eleven sectors' we have taken top one company from each

sector. (everage is independent variable is our study and we have taken total debt ratio as pro%y

for leverage' as total debt ratio is one of leverage ratios. )rofitability is dependent variable and we have taken *eturn on investment as pro%y for profitability as *O& is one of the profitabilityratios. +ata is collected from annual reports of the companies. We used (inear *egression

,odel with ordinary least s uare method to check the relationship between two variables. *esults showed that there is significant positive relation between leverage and profitability. (evered firms are more profitable than non-levered firm or a firm can enhance its profitability byusing debts. Our study has further implications for researcher to calculate what particular

percentage of leverage can bring ma%imum possible profit for a firm and hence to find anoptimal capital structure.

Introduction:

One of the best ways in which company increases its profit is through financial leverage.Financial leverage uses debt instruments so that the anticipated level return on the company'sequity would increase. The level of financial leverage of a certain company is determined bygetting the total value of debt and the equity and the ratio of debt.

Leverage is commonly described as the use of borrowed money to make an investment andreturn on that investment.

It is more risky for a company to have a high ration of financial leverage. It has also been noticedthat on the outcome of financial leverage if the level or point of financial leverage is high! themore rise is anticipated profit on company's equity. Thus! financial leverage is used in variouscircumstances as a means of altering the cash flow and financial position of a company

Literature Review:


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"hah #halid made a research on $naly%ing the Impact of Leverage and $d&ustment osts on(arious )easures of orporate *erformance. This study investigates effect of leverage andad&ustment costs on various measures of corporate performance for +,- non financial firms listedon #arachi "tock /0change of *akistan. The $rellanoand 1ond dynamic panel data estimationtechnique is used .(ariables used are 2eturn on equity! earning per share! return on capitalemployed 3 leverage. The results obtained are mi0ed. The coefficients of the ad&ustmentvariable are positive for 2eturn on capital employed and /arnings per "hare but ironicallynegative for 2eturn on /quity. "imilarly the effect of leverage on 2O/ is negative butinsignificant and positive significant when /*" is used as a measure of corporate performance.4hereas the relationship between leverage and 2O/ is negative and significant which impliesthat high leverage force the managers to perform optimally due to higher interest burden andagency cost

2amachandran $%hagaiah 3 "elvara& "athia made a study on orporate Leverage and Financial

5ecision in the Indian Te0tile Industry! in which 67 te0tile firms! which are listed in 1ombay"tock /0change are taken as a sample for the study period from 688- to 6889. "tatistical toolsthat have been used are correlation and regression methods. (ariables used are leverage! earning

per share! earnings before interest 3 ta0! profitability 3 liquidity ratios. The study reveals thatthe firms i. e. acm! afl! asl! basml! bcil! gsm! gdpm and ge&ml show significant growth rate infinancial! operating and combined leverage.

2ashmi 1anga and :day 1hanu "inha made a study on effect of debt on investment strategies of a firm.

The study e0amines the impact of total debts! short term debts and long term debts on the

output! gross investments and technology upgrading strategies of the firms in certain

oligopolistic industries in India. 4e have selected total +6 industries with ;-< firms .variablesused are ratio of sales turnover! research 3 development! investment ratios! gross profit! earnings

before interest 3 ta0. The empirical analysis shows that debt as a whole may have a negativeimpact on the choice of output and investment levels of the firms. =owever! the short term debtsmake firms behave in a conservative fashion while the long term debts make firms behave moreaggressively in this respect.

)ahira 2afique conducted a research on effect of profitability 3 financial leverage on capitalstructure of *akistani automobiles firm. This study focuses on investigating the effect of the

profitability of the firm and its financial leverage on the capital structure of the automobile sector companies in *akistan! the capital structure of ;; listed firms has been analy%ed over a period of five years. Independent variable in it is profitability 3 financial leverage while dependentvariable is capital structure. /stimating regression analysis and checking the relationship of theestimated model through orrelation oefficient Test! we found that the profitability of the firmand its financial leverage have an insignificant impact on the capital structure of the studiedfirms during the e0amined period


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ora%on L. )agpayo conducted research on effect of 4orking apital )anagement andFinancial Leverage on Financial *erformance of *hilippine Firms. The study aims to determinethe effect of working capital management policy and financial leverage on financial performanceof *hilippine firms measured in terms of net income! return on equity >2O/? and return on asset>2O$?. *earson@s rank correlation test! $AO($ F test! and multiple regression analysis wereused on ;;8 randomly selected. Independent (ariable in it are 4orking capital management

policy 3Financial leverage management 5ependent (ariables are Aet income! 2eturn on $sset3 2eturn on /quity .2esults of the study indicated that firm@s working capital management

policy! financial leverage! and firm si%e have significant relation to net income. =owever working capital management policy has no significant effect on return on equity >2O/? andreturn on assets >2O$?.

#uben 2ayan conducted research on relationship between financial leverage 3 the firm value.The purpose of the study is to evaluate weather in a "outh $frican conte0t an increase in

financial leverage positively or negatively affect firm value. The research was conducted usingsecondary data included ;;+ listed companies in the Bohannesburg stock e0change. (ariablesused are leverage! growth 3 profitability. 2egression analysis was used. It was found thatleverage is negatively correlated with firm value.

"immi #hurana; and ).L. Cupta conducted study on Impact of Leverage on *rofitability of *harmaceutical ompanies. The study aim at e0plains the impact of leverage on profitability of

pharmaceutical companies in India. The ob&ective of this study is to study the relationship between debt and equity components and financial decisions 3 factors influencing the financingdecision. "tatistical tools were used average >mean?! dispersion >standard deviation! scenes!

correlation! and kurtosis?. orrelation analysis technique 3 T test is also used. (ariables used arefinancial leverage! profitability! operating leverage 3 earning per share.It is concluded that /arning per share of company is not depend upon only on the debt capital incapital structure. *rofits can be increased by using debt capital structure due to ta0 advantage.The optimal capital structure of companies is depend upon other factors like "i%e! growth!uniqueness! *rofitability ! ollateral value of assets not only on leverage.

$ "achchidanand *achori! 5r. Aavindra #. Totala conducted research onInfluence of FinancialLeverage on "hareholders 2eturn and )arket apitali%ation. The study e0plores the effect of financial leverage on shareholders@ return and market apitali%ation. "imple linear regressionanalysis was carried out to &udge the impact of financial leverage on shareholders@ return andmarket capitali%ation individually to find out the state of influence of the leverage. Thedependent variables are shareholders@ return and market capitali%ation. The independent variableis financial leverage. It is concluded that there is no significant influence of financial leverage onshareholders@ return and market capitali%ation.


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Dasim "aleem 3 )uhammad $kram Aaseem conducted a research on Impact of leverage on*rofitability! with 2eference to "elected Oil and Cas ompanies of *akistan. The main ob&ectiveof this study was to analy%e and understand the effect of leverage on the profitability of the oiland gas sector of *akistan. It aims to analy%e how earning capacity of this sector is affected byoperating costs and fi0ed financial charges. "tatistical methods used are of one way $AO($ andt test. 5ependent variables in it are 2eturn on assets! 2eturn on equity! 2eturn on Investments 3/arning per share .Independent variables are Financial Leverage 2atio! Operating Leverage. Thisresearch failed to support the positive relationship between financial leverage and both profitmeasures. The results indicated that high leveraged firms were less risky in due to the presencesof debt shield.

". handrakumarmangalam 3 *. Covindasamy conducted a research on Impact leverage on*rofitability with 2eference to "elected ement ompanies in IndiaThis study investigates the relationship between the leverage >financial leverage! operating

leverage and combined leverage? and the earning per share. $nd it aims to describe how theearning capacity of the firm is influenced by the fi0ed operating costs and the fi0ed financialcharges. The analysis technique used are one way $AO($ and t test. The results suggest thatthe leverage and profitability and growth are related and the leverage is having impact onthe profitability of the firm.The study is based on secondary data and only the period of , yearsis taken for analysis. The study is based on secondary data and only the period of , years is takenfor analysis.

$kinmulegun "unday O&o conducted the research on the effect of financial leverage on corporate performance of some selected companies in Aigeria. This study empirically e0amines the effect

of financial leverage on selected indicators of corporate performance in Aigeria. The broadob&ective of the study is to e0amine the impact of leverage on the earnings per share and netassets per share of corporate firms in Aigeria. /conometric Technique of (ector $uto 2egression>($2? model was employed variables used are /arnings per share! Aet asset per share3leverage. The findings revealed that Leverage shocks e0ert substantially on corporate

performance in Aigeria. In addition! /arnings per "hare >/*"? depends more on feedback shock and less on leverage shock. Leverage therefore significantly affects corporate performance in

Aigeria

/un&u Eoon and "oocheong &ang conducted a research on the effect of financial leverage on profitability and risk of restaurant firms. This study presents an empirical insight into therelationship between return on equity >2O/?! financial leverage and si%e of firms in therestaurant industry for the period ; 9 to 688+ using OL" regressions. variables used arefinancial leverage as independent variable while profitability 3 2isk taken as dependentvariables. This study presents an empirical insight into the relationship between return on equity>2O/?!financial leverage and si%e of firms in the restaurant industry for the period ; 9 to 688+using OL" regressions.


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)ing hang heng and Guwei hing T%eng conducted a research on the effect of leverage onfirm value and how The firm financial quality influence its profitability.This study applied theCenerali%ed )ethod of )oment >C))? to estimate the effect of leverage on firm values andconte0tual variables influencing on this relationship. :sing


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Total 5ebt 2atio H Total 5ebts Total $ssets

"ependent +ariable:

2eturn on $ssets >2O$? H Aet *rofit Total $ssets

"!'! C LL#C'I :4e took data for five years from 6887 to 688 for eleven companies listed in #arachi "tock /0change. "election of companies made on the basis of #"/ +8 Inde0. $s #"/ +8 Inde0consists of eleven sectors we took top one company from each sector. 4e collected data for eachcompany from their annual reports. Total observations were 77 >;;J7?.

$#'% " L ,&:

4e used panel data analysis by using OL" assuming that all the intercepts and slope coefficientsare constant over time and individuals. 4e used /views, for our study to reach a conclusionabout relation between leverage and profitability.

$ "#L :

R !- ./ 0 1// "R 02i4here2O$H2eturn on $ssets52HTotal 5ebt 2atio

: i H /rror Term

$ "#L # 'I$!'I :The panel data analysis is performed by using OL" assuming that all the intercept and slope coefficient are same over time and individual. :sing /views, we found following results

5ependent (ariable 2O$)ethod *anel Least "quares5ate 8; 6< ;+ Time 8, +"ample 6887 688*eriods included 7ross sections included ;;Total panel >balanced? observations 77

(ariable oefficient "td. /rror t "tatistic *rob.


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2 squared 8.-;+67; )ean dependent var .++7-77$d&usted 2 squared 8.-86;98 ".5. dependent var


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Observations 77 77#$PIRIC!L R# 2L' :The results show from linear regression analysis 2O$ is significantly affected by leverage ratiothat was total debt ratio.. $ccording to this empirical results p value is less than ;8 of Leverageratio therefore we re&ected the null hypothesis and consequently conclude that there is significant

positive relation between leverage and profitability by accepting alternate hypothesis. Thereforevalue is "./? is 8.8+ , and p value is 8.86887? NThe /ffect of Financial Leverage on *rofitability and2isk of 2estaurant Firms !N ournal of /ospitality inancial ,anagement (ol. ;+ Iss. ;! $rticle6-.

=yun Oh #ang! 1.".>68;;? Impact of Financial Leverage on *rofitability in Lodging

ompaniesP 1ournal of financial economics 6>+? pp. 8- 67

". handrakumarmangalam! *. Covindasamy >68;8? Leverage Q $n $nalysis and its Impact on*rofitability with 2eference to "elected ement ompanies in IndiaP "uropean ournal of

"conomics' inance and &dministrative ciences . (olume + pp.; 66


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Impact of Leverage Ratio on Profitability

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