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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 draw
the conclusion that levered firm have advantage over non-levered firm. We have taken data of
five year i.e. from 2005-2009. Sample consists of eleven companies which are chosen from KSE
30 Index. As KSE 30 Index consists of eleven sectors, we have taken top one company from each
sector. Leverage is independent variable is our study and we have taken total debt ratio as proxy
for leverage, as total debt ratio is one of leverage ratios. Profitability is dependent variable and
we have taken Return on investment as proxy for profitability as ROA is one of the profitability
ratios. Data is collected from annual reports of the companies. We used Linear Regression
Model with ordinary least square method to check the relationship between two variables.
Results showed that there is significant positive relation between leverage and profitability.
Levered firms are more profitable than non-levered firm or a firm can enhance its profitability by
using debts. Our study has further implications for researcher to calculate what particular
percentage of leverage can bring maximum possible profit for a firm and hence to find an
optimal 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's
equity would increase. The level of financial leverage of a certain company is determined by
getting 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 and
return on that investment.
It is more risky for a company to have a high ration of financial leverage. It has also been noticed
that on the outcome of financial leverage: if the level or point of financial leverage is high, the
more rise is anticipated profit on company's equity. Thus, financial leverage is used in various
circumstances as a means of altering the cash flow and financial position of a company
Literature Review:

Shah Khalid made a research on Analyzing the Impact of Leverage and Adjustment Costs on
Various Measures of Corporate Performance. This study investigates effect of leverage and
adjustment costs on various measures of corporate performance for 374 non-financial firms listed
on Karachi Stock Exchange of Pakistan. The Arellanoand Bond dynamic panel data estimation
technique is used .Variables used are Return on equity, earning per share, return on capital
employed & leverage. The results obtained are mixed. The coefficients of the adjustment
variable are positive for Return on capital employed and Earnings per Share but ironically
negative for Return on Equity. Similarly the effect of leverage on ROE is negative but
insignificant and positive significant when EPS is used as a measure of corporate performance.
Whereas the relationship between leverage and ROE is negative and significant which implies
that high leverage force the managers to perform optimally due to higher interest burden and
agency cost
Ramachandran Azhagaiah & Selvaraj Sathia made a study on Corporate Leverage and Financial
Decision in the Indian Textile Industry, in which 25 textile firms, which are listed in Bombay
Stock Exchange are taken as a sample for the study period from 2004 to 2008. Statistical tools
that have been used are correlation and regression methods. Variables used are leverage, earning
per share, earnings before interest & tax, profitability & liquidity ratios. The study reveals that
the firms i. e. acm, afl, asl, basml, bcil, gsm, gdpm and gejml show significant growth rate in
financial, operating and combined leverage.
Rashmi Banga and Uday Bhanu Sinha made a study on effect of debt on investment strategies of
a firm. The study examines 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. We have selected total 32 industries with 146 firms .variables
used are ratio of sales turnover, research & development, investment ratios, gross profit, earnings
before interest & tax. The empirical analysis shows that debt as a whole may have a negative
impact on the choice of output and investment levels of the firms. However, the short-term debts
make firms behave in a conservative fashion while the long-term debts make firms behave more
aggressively in this respect.
Mahira Rafique conducted a research on effect of profitability & financial leverage on capital
structure of Pakistani 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 Pakistan, the capital structure of 11 listed firms has been analyzed over a period of
five years. Independent variable in it is profitability & financial leverage while dependent
variable is capital structure. Estimating regression analysis and checking the relationship of the
estimated model through Correlation Coefficient Test, we found that the profitability of the firm
and its financial leverage have an insignificant impact on the capital structure of the studied
firms during the examined period

Corazon L. Magpayo conducted research on effect of Working Capital Management and


Financial Leverage on Financial Performance of Philippine Firms. The study aims to determine
the effect of working capital management policy and financial leverage on financial performance
of Philippine firms measured in terms of net income, return on equity (ROE) and return on asset
(ROA). Pearsons rank correlation test, ANOVA F-test, and multiple regression analysis were
used on 110 randomly selected. Independent Variable in it are Working capital management
policy &Financial leverage management Dependent Variables are Net income, Return on Asset
& Return on Equity .Results of the study indicated that firms working capital management
policy, financial leverage, and firm size have significant relation to net income. However
working capital management policy has no significant effect on return on equity (ROE) and
return on assets (ROA).
Kuben Rayan conducted research on relationship between financial leverage & the firm value.
The purpose of the study is to evaluate weather in a South African context an increase in
financial leverage positively or negatively affect firm value. The research was conducted using
secondary data included 113 listed companies in the Johannesburg stock exchange. Variables
used are leverage, growth & profitability. Regression analysis was used. It was found that
leverage is negatively correlated with firm value.
Simmi Khurana1 and M.L. Gupta conducted study on Impact of Leverage on Profitability of
Pharmaceutical Companies. The study aim at explains the impact of leverage on profitability of
pharmaceutical companies in India. The objective of this study is to study the relationship
between debt and equity components and financial decisions & factors influencing the financing
decision. Statistical tools were used average (mean), dispersion (standard deviation, scenes,
correlation, and kurtosis). Correlation analysis technique & T-test is also used. Variables used are
financial leverage, profitability, operating leverage & earning per share.
It is concluded that Earning per share of company is not depend upon only on the debt capital in
capital structure. Profits can be increased by using debt capital structure due to tax advantage.
The optimal capital structure of companies is depend upon other factors like Size, growth,
uniqueness, Profitability ,Collateral value of assets not only on leverage.
CA Sachchidanand Pachori, Dr. Navindra K. Totala conducted research onInfluence of Financial
Leverage on Shareholders Return and Market Capitalization. The study explores the effect of
financial leverage on shareholders return and market Capitalization. Simple linear regression
analysis was carried out to judge the impact of financial leverage on shareholders return and
market capitalization individually to find out the state of influence of the leverage. The
dependent variables are shareholders return and market capitalization. The independent variable
is financial leverage. It is concluded that there is no significant influence of financial leverage on
shareholders return and market capitalization.

Qasim Saleem & Muhammad Akram Naseem conducted a research on Impact of leverage on
Profitability, with Reference to Selected Oil and Gas Companies of Pakistan. The main objective
of this study was to analyze and understand the effect of leverage on the profitability of the oil
and gas sector of Pakistan. It aims to analyze how earning capacity of this sector is affected by
operating costs and fixed financial charges. Statistical methods used are of one way ANOVA and
t test. Dependent variables in it are Return on assets, Return on equity, Return on Investments &
Earning per share .Independent variables are Financial Leverage Ratio, Operating Leverage. This
research failed to support the positive relationship between financial leverage and both profit
measures. The results indicated that high leveraged firms were less risky in due to the presences
of debt shield.
S. Chandrakumarmangalam & P. Govindasamy conducted a research on Impact leverage on
Profitability with Reference to Selected Cement Companies in India
This study investigates the relationship between the leverage (financial leverage, operating
leverage and combined leverage) and the earning per share. And it aims to describe how the
earning capacity of the firm is influenced by the fixed operating costs and the fixed financial
charges. The analysis technique used are one way ANOVA and t-test. The results suggest that
the leverage and profitability and growth are related and the leverage is having impact on
the profitability of the firm.The study is based on secondary data and only the period of 7 years
is taken for analysis. The study is based on secondary data and only the period of 7 years is taken
for analysis.
Akinmulegun Sunday Ojo conducted the research on the effect of financial leverage on corporate
performance of some selected companies in Nigeria. This study empirically examines the effect
of financial leverage on selected indicators of corporate performance in Nigeria. The broad
objective of the study is to examine the impact of leverage on the earnings per share and net
assets per share of corporate firms in Nigeria. Econometric Technique of Vector Auto Regression
(VAR) model was employed variables used are Earnings per share, Net asset per share&
leverage. The findings revealed that Leverage shocks exert substantially on corporate
performance in Nigeria. In addition, Earnings per Share (EPS) depends more on feedback shock
and less on leverage shock. Leverage therefore significantly affects corporate performance in
Nigeria
Eunju Yoon and Soocheong jang conducted a research on the effect of financial leverage on
profitability and risk of restaurant firms. This study presents an empirical insight into the
relationship between return on equity (ROE), financial leverage and size of firms in the
restaurant industry for the period 1998 to 2003 using OLS regressions. variables used are
financial leverage as independent variable while profitability & Risk taken as dependent
variables. This study presents an empirical insight into the relationship between return on equity
(ROE),financial leverage and size of firms in the restaurant industry for the period 1998 to 2003
using OLS regressions.

Ming-Chang Cheng and Zuwei-Ching Tzeng conducted a research on the effect of leverage on
firm value and how The firm financial quality influence its profitability.This study applied the
Generalized Method of Moment (GMM) to estimate the effect of leverage on firm values and
contextual variables influencing on this relationship. Using 645 companies listed in Taiwan
Securities Exchange (TSE) from 2000-2009.variables used are value of firm, market value of
equity, fixed asset, total liabilities of a firm, the book value of long-term debt and total short-term
or current liabilities. The empirical results show that the values of leveraged firm are greater
than that of an unleveraged firm if we dont consider bankruptcy probability. Secondly, If we
consider the benefit and cost of debt simultaneously, the leverage is significantly positively
related to the firm value before reaching firm optimal capital structure.
Arif Singapurwoko & Muhammad Shalahuddin Mustofa El-Wahid conducted the research on the
impact of financial leverage to profitability study of Non-Financial Companies Listed in
Indonesia Stock Exchange. There are several factors that can affect the companies profitability.
This research uses operational decision factor, macroeconomics factor, firm size factor, and
industry factors to help understand the effect of debt to profitability. Regression analysis used for
this research. Equity multiplier, firm size& the industry will be the independent variables, while
the dependent variable will be ROE. The result shows that debt, firm size, and operational
decision effect positively significant, and macroeconomics effect insignificantly towards
profitability. In addition, industry factor is found to affect companies profitability.

BROAD PROBLEM AREA:


Checking effect of leverage on profitability of Pakistani firms by using leverage ratio and
profitability ratio, taking eleven top companies of KSE 30 Index, during 2005-2009
HYPOTHESES:
H0: There is no significant relationship between leverage and profitability
H1: There is significant relationship between leverage and profitability
SELECTION OF VAIABLES:
Independent Variable:

Total Debt Ratio = Total Debts / Total Assets


Dependent Variable:
Return on Assets (ROA) = Net Profit / Total Assets
DATA COLLECTION:
We took data for five years from 2005 to 2009 for eleven companies listed in Karachi Stock
Exchange. Selection of companies made on the basis of KSE 30 Index. As KSE 30 Index
consists of eleven sectors we took top one company from each sector. We collected data for each
company from their annual reports. Total observations were 55 (11*5).
METHODOLOGY:
We used panel data analysis by using OLS assuming that all the intercepts and slope coefficients
are constant over time and individuals. We used Eviews7 for our study to reach a conclusion
about relation between leverage and profitability.
MODELS:
ROA= 1 + 11 DR +Ui
Where:
ROA=Return on Assets
DR=Total Debt Ratio
Ui = Error Term

MODEL ESTIMATION:
The panel data analysis is performed by using OLS assuming that all the intercept and slope coefficient are same over time and individual. Using Eviews7 we found following results:
Dependent Variable: ROA
Method: Panel Least Squares
Date: 01/26/13 Time: 07:39
Sample: 2005 2009
Periods included: 5
Cross-sections included: 11
Total panel (balanced) observations: 55
Variable

Coefficient

Std. Error

t-Statistic

Prob.

C
L

6.180784
0.242871

0.822563
0.039752

3.514057
6.109685

0.0000
0.0604

R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
F-statistic
Prob(F-statistic)

0.413251
0.402180
4.748703
1195.160
-162.7059
37.32826
0.000000

Mean dependent var


S.D. dependent var
Akaike info criterion
Schwarz criterion
Hannan-Quinn criter.
Durbin-Watson stat

Estimation Equation:
=========================
ROA = C(1) + C(2)*L
Substituted Coefficients:
=========================
ROA = 6.18078393338 + 0.242870777806*L

DESCRIPTIVE STATS:

ROA

Mean
Median
Maximum
Minimum
Std. Dev.
Skewness
Kurtosis

12.98909
6.500000
60.00000
0.700000
16.25630
1.533585
4.164561

9.335455
9.500000
29.00000
0.500000
6.141719
0.574899
3.236467

Jarque-Bera
Probability

24.66690
0.000004

3.157811
0.206201

Sum
714.4000
Sum Sq. Dev. 14270.43

513.4500
2036.918

9.335455
6.141719
5.989306
6.062300
6.017533
1.369051

Observations

55

55

EMPIRICAL RESULTS:
The results show from linear regression analysis ROA is significantly affected by leverage ratio
that was total debt ratio.. According to this empirical results p-value is less than 10% of Leverage
ratio therefore we rejected the null hypothesis and consequently conclude that there is significant
positive relation between leverage and profitability by accepting alternate hypothesis. Therefore
value is 6.18 that is the constant value and independent variable Ls value is 0.243 that means
that ROA is directly affected by 0.243L so standard error (S.E) is 0.0397 and p-value is 0.0604
and R Square value come out 0.413. So leverage directly and positively affects profitability,
other detailed results are mentioned in table given above.
CONCLUSION:
The More generally, by our humble attempt to empirically address the relationship between debt
ratio and profitability, there is a positive relation between debt used by Pakistnai firms and their
profitability. It can be therefore concluded that levered firms are more profitable than non
levered firm. Another aspect from investors side is that investors should prefer to choose levered
firms as their profitability is comparatively greater than non levered firm. However our research
can serve as an initial step for profitability and leverage relationship.
LIMITATIONS:
Our research has following limitations; however it serves as initial step profitability and leverage
relationship
o Sample consists of only eleven companies because of unavailability of data, therefore it
may not represent all Pakistani firms
o Only one independent variable is used i.e. total debt ratio there are some other variables
that can effect profit of any firm
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