Profitability In The Market Example For Free - Free Essay Example

At the overall level and in sector wise analysis the data from the sample indicates that an increase in the debt ratio leads to lower profitability measured by net income before taxes divided by total assets. Profitability is found to be negatively correlated with firms debt ratio and this relationship is statistically significant in both sectors. It means that profitable firms in Pakistani banking and insurance sector maintain low debt ratios. To justify this negative relationship between profitability and debt ratio of the firm we would say that most of the Pakistani firms try to retain its earning for future requirements as they prefer to pick internal financing over external financing. Another reason for the negative relationship is that debt translates into higher fixed costs as it must still be paid even if demand declines, at low level of demand, the fixed cost are spread over a smaller base, depressing profitability White, Sondhi and Fried (1997). This point could help explain why an increase in the debt ratio leads to a decline in profitability-it is possible that the corresponding change in sales volume did not compensate for the increase in fixed costs. Frydenberg (2001) describes retained earnings as the most important source of financing, good profitability thus reduces the need for external debt. And firms in the banking and insurance sector have shown good profitability during the period of the study. This result is against the Modigliani and Miller (1958) view on capital structure and the optimal capital structure theory that postulates that profitability should be increased by an increase in the firm level of debt. The underlying assumption for all this to hold true is that the firms operate in efficient market environment, and this might not necessarily be the case with the KSE listed companies. The findings are also inconsistent with the conclusion of Fama and French (2002), Sharma (2006), Ward and Price (2006) all of whom conc lude that there is a positive relationship between profitability and debt ratio. However, the result is consistent with the prediction of Pecking order theory by Myers and Majluf (1984) that Firms first use retained earnings for new investments and then move to debt and equity if required. The result supports the findings of Rajan and Zingales (1995) who find a negative relationship between profitability and debt ratio. Frank and Goyal (2004) conducted an empirical study in which he found evidence that firms with high profitability will have less debt. A possible explanation for this result can be drawn from De Wet (2006) who showed that significant amount of value can be unlocked in moving closer to the optimal level of gearing and Modigliani and Miller (1963) who says that a firm cost of equity increases as the firm increases its debt. Further our result is also consistent with Titman Wessels (1988). Whereas, the predictions of trade-off theory presented by Jensen Meckling (1984 ) are not substantiated. Hence, with highly significant negative relationship between profitability and debt ratio, we can conclude that high profitable firms maintain low debt ratio and they utilize more of their retained earnings compared to debt for making their capital structure. It is thus proved that pecking order theory dominates trade-off theory. Shah and Hijazi (2004), Jean-Laurent Viviani (2004), Shah and Khan (2007) Jasir ilyas (2008), Abubakar sayeed (2010), Joy pathak (2010) all find negative relationship between profitability and debt ratio. In contrast, Fakher Buferna, Kenbata Bangassa and Lynn Hodgkinson (2008) find that profitable firms will have high debt ratio, while Fitim Deari and Media Deari (2009) find negative relation in case of listed companies and positive incase of unlisted companies. Tangibility of assets Tangibility, with positive coefficient is significantly related to debt in overall findings. The result also shows significant positive relati onship between tangibility and debt ratio in the insurance sector. This indicates that tangibility is one of the most important determinants of debt ratio in the insurance sector of Pakistan. The finding is in conformity with the prediction of Jenson and Meckling (1976) and Myers (1977) version of trade-off theory. The reason for the positive relationship between tangibility and debt ratio in the insurance sector of Pakistan is quite obvious. The advantage of debt investment is that creditors receive uninterruptible stream of income due to debt investment except in case of bankruptcy. Creditors have no tension about the interest payment by firm on their debt, if the firm is performing well. But it well be difficult for them to continuously monitor the operations and performance of the firm, therefore they can overcome this trouble by asking the security of fixed assets like land, building, machinery etc. Thus creditors will be willing to give loans to those firms who provide there f ixed assets as a security against debt. Therefore firms with less fixed assets cannot borrow large amount of debt because of high cost of debt, but on the other hand firms with higher amount of fixed assets in total assets can borrow more due to lower interest rate. For example companies like EFUG insurance, East west insurance, Pakistan reinsurance and Asian insurance who have more fixed assets have high debt ratio, against a low debt ratio of Central insurance and IGI insurance etc who have less fixed assets. Jean-Laurent Viviani (2004) on French wine companies, Shah and Khan (2007) on 286 KSE listed non financial firms, Jasir ilyas (2008) on 364 non financial firms and Joy pathak (2010) in his investigation into 139 Indian firms also find significant positive relationship between tangibility and debt ratio. However this finding is in contrast to the earlier finding by Shah and Hijazi (2004) on 445 non financial firms, Fakher Buferna, Kenbata Bangassa and Lynn Hodgkinson (2008) on a sample of 55 Libyan companies, Fitim Deari and Media Deari (2009) on Macedonian listed and unlisted companies and Naveed, Zulfiqar and Ishfaq (2010) in life insurance sector of Pakistan. They found that tangibility was not significantly related to debt ratio. The coefficient of the variable tangibility of assets is negative and is statistically significant as for as banking sector is concerned. This result is against various previous research findings. According to trade-off theory and agency cost theory there is positive relationship between debt ratio and tangibility of assets. Firms borrowing capability depends upon assets that have collateralizable value Rajan and Zingales (1995), Frank and Goyal (2004). The negative relationship between tangibility and debt ratio in the banking sector support the Pecking order theory, which says that firms with less collateralizable value of assets tends to finance their investments projects with external financing and they will prefer de bt over equity, most likely short term debt. The debt maturity structure of the banking system of Pakistan consists of large amount of short term debt against a very small amount of long term debt. Booth et al (2001) in his investigation in to 10 developing countries including Pakistan and Shah and Hijazi (2004) on KSE listed firms; find that firms have higher utilization of short term debt in total debt in Pakistan. They justify this by saying that as majority of firms are smaller in size therefore their access to capital market is difficult in terms of cost and technical difficulties. There are three potential sources according to World Banks policy research department report (1997) that affect on accessibility of long term financing: Macroeconomic factors limiting the long term financing, such as high inflation and unstable macro policies. Institutional factors specific to the financial sector,e.g; there most likely be less information about small firms available to fina ncial institutions, not only due some of them will be new but also because it is costly to obtain such information and size is considerable characteristic of firms that affects on access to long term financing. The characteristics of the firms. In banking sector of Pakistan where short term financing is higher 95% than long term financing, our result (negative sign) is significant under short term financing and consistent with Pecking order theory. The negative relationship between tangibility and debt ratio for banking sector suggests that firms in the banking sector do not use their fixed assets as collateral for obtaining debt financing. The reason may be that as the government has the majority of ownership in the banking sector, the debt holders take government involvement as collateral instead of the firms fixed assets. According to Khan (1995), Khan and Khan (2007); in Pakistan the banking sector has been dominated by government owned institutions, it has accommodated th e financial needs of the government, public enterprises and private sectors. Another reason for negative relationship may be that Companies with few tangible assets are more subject to information asymmetry problems, and therefore, more willing to use debt to finance their activities. In our case this is true; because the asset maturity structure of the banking system of Pakistan consists of large amount of short term assets against a very small amount of fixed assets, and also firms are evaluated from lenders not just based on tangibility of assets, but also from others perspectives, i.e. goodwill etc. In a questionnaire forward to managers of Macedonian companies by Fitim Deari and Media Deari (2009), major of them believe that for approving loans, in their business plan profitability and growth are onward than tangibility. Abubakar sayeed (2007) in energy sector of Pakistan also find negative relation between tangibility of assets and financial leverage. Liquidity Similarly , the results between liquidity of the firms and its debt ratio show significant negative relationship in banking as well as in the insurance sectors of Pakistan. Liquidity of the firms is measured using current ratio, which is expressed as current assets divided by current liabilities, showing the ability of the firm to deal with its short term liabilities. Companies with high liquidity tend to use less amount of debt, simply because it provides an indication that firms generally finance their activities by following pecking order theory. Firms in the banking and insurance sectors maintain high liquidity therefore they are able to generate high cash inflows and in turn, can employ the excess cash inflow to finance their operations and investment activities. Therefore, they use less debt compared to those firms in the two sectors that have low liquidity as suggested in pecking order theory. As for low liquidity firms, they tend to go for debt in financing their activities. The re sult is similar to the findings of Eriotis, Vasilou and Neokosmidi (2007) in a study of capital structure of 129 Greek companies listed in the Athens Stock Exchange, Suhaila, Mat Kila and Wan Mahmood, Wan Mansor (2008) in a study of 17 Malaysian companies listed in Bursa Malaysia Bhd, Kuala Lumpur, Naveed, Zulfiqar and Ishfaq (2010) on four companies from life insurance sector in the Karachi Stock Exchange and joy pathak (2010) on 139 Indian firms. Size The relationship between size and dependent variable debt ratio is positive and statistically significant for the banking as well as the insurance sector. This means that larger firms in the two sectors have high debt ratio. Considering the fact that large firms are more diversified, bear less risk and have more consistent cash flows, therefore they can afford higher levels of debt. For example Allied bank limited, National bank of Pakistan, Habib bank limited, MCB bank and united bank limited etc which are the largest banks ha s the highest debt ratio as compare to smaller banks like samba bank, first credit and investment bank and my bank limited etc. and in the insurance sector Adamjee insurance, EFUG insurance, Asian insurance has high debt ratio against a low debt ratio of Central insurance, IGI insurance and Pakistan general insurance. This result is supported by trade-off theory (bankruptcy cost theory) that fixed direct costs of bankruptcy consist of a smaller portion of the total value of the firm thus larger firms do not hesitate to take more debt because of fear of bankruptcy. For larger firms this cost is smaller and it makes easy for them to obtain debt. Further, larger listed firms in the two sectors of Pakistan have state ownership (partial or complete state controlled) that facilitates them with less chance of bankruptcy and easy access to debts. Majority of empirical studies that include the data from developing countries find a positive relation between size and debt ratio. For example: T itman and Wessels (1988), Rajan and Zingales (1995), Booth et al; (2001), Shah and Hijazi (2004), Abubakar sayeed (2007), Fitim Deari and Media Deari (2009), Naveed, Zulfiqar and Ishfaq (2010), provide the evidence of significant direct relationship between size and debt ratio. In contrast Shah and Khan (2007) and Suhaila, Mat Kila and Wan Mahmood, Wan Mansor (2008) found that size is not a proper explanatory variable of debt ratio. Since our result has a significant statistics so we can claim that size does have significant role in making debt ratio and determining the capital structure of Pakistani firms in banking and insurance sector. Larger firms use more debt rather than equity to raise their financing. Non-debt tax shield The literature on capital structure suggests that non-debt tax shields like depreciation reduce the need for debt to stop net income from going to next high tax brackets. The variable non-debt tax shield is found to be negatively related to debt rat io in all findings but statistically insignificant. Thus this result is not consistent with the predictions of trade-off theory of capital structure. One reason for this statistically insignificant relation between the explanatory variable non-debt tax shield and dependent variable debt ratio is that in Pakistan, tax rate does not vary with the level of income. There are three straight rates in Pakistan: One applicable to commercial organizations in government ownership Second to public limited companies And third to organizations in financial sector Therefore non-debt tax shield (depreciation) does not work as a substitute to leverage to stop net income from going into a next high tax bracket. Therefore, in other words the amount or level of depreciation is not considered in making capital structure decision. This result is consistent with the results of Shah and Khan (2007), Abubakar sayeed (2007), Jasir ilyas (2008) and Fitim Deari and Media Deari (2009) who also find that non-debt tax shield is insignificantly related to debt ratio. However, Ozkan (2001); Banerjee, et al. (2000), Huang and Song (2005), Flannery and Rangan (2006) and Ziad Zurigat (2009) find significant negative relationship between NDTS and debt ratio. In contrast Delcoure (2007) found positive relation between the two, in the context of central and eastern European countries. Growth The growth variable has a significant positive impact on the dependent variable debt ratio as for as banking as well as insurance sector is concerned. Thus our result support the pecking order theory presented by Myer and Majluf (1984) which predicts that growth variable and debt ratio are positively related, and says that if external funds are required firms will prefer debt over equity due to lower information costs associated with debt, because for a growing firm their internal funds might not be sufficient to meet their requirements and to finance their positive investment oppurtunities a nd hence, they are likely to be in need of external funds and therefore, they will use debt to finance their investment activities and expand their business. Firms in the two sectors achieved a high growth rate in the period 2002-2009. This result means that firms with higher growth rate maintain higher debt ratio. Growth is founded a significant factor for deciding the capital structure decisions in the two sectors of Pakistan and firms with high growth rates borrow more than firms with low growth rates. Myers (1977) studied growth options, and argues that corporate future investment opportunities can be considered as options. These growth options value then depends on the probability that the companies will exercise them optimally. He further suggests that a firm may pass up some profitable investment opportunities in the presence of risky debt, which is also called the problem of under-investment. However, such problems will not arise, if firms have more debt of short maturity in their capital structure, because the firm will pay the debt before the growth option expires. Most of the Pakistani firms finance their investment projects by short term financing, they has a large amount of short term debt in total debt as compare to long term debt Shah and Hijazi (2004). Thus the finding is similar to Myers (1977) prediction that firms with greater amount of short term debt will have higher growth options in order to reduce the costs of shareholder-bondholder conflicts has been confirmed by empirical studies. According to Garcia-Teruel and Martinez-Solano (2007) short-term debt is more common in firms with major growth options. Shah and Hijazi (2004), Cai et al. (2008), KÃ ´rner (2007) and Joy pathak (2010) also find similar results. In contrast, Fakher Buferna, Kenbata Bangassa and Lynn Hodgkinson (2008) find negative relationship between growth and debt ratio. Booth et al, (2001) argue that there is positive relation between debt ratio and growth in almost all countries in their sample. Pandey (2001) also finds a positive relation in the context of Malaysia.