International Peer-Reviewed Journal  
Arvind Dhond  
Capital structure can be defined as the mixture of firm’s capital with debt and equity and it has been  
one of the most argumentative subjects in corporate finance, since the outstanding study of Modigliani  
and Miller in 1958. The present study emphasise on a main concept in the study of corporate finance  
which is applicable to all kinds of firms. The conclusions of this study are that high level of debt does  
not automatically boost Return on Equity (ROE) and thus needs purposeful action by finance people.  
Key Words : Capital Structure, Debt, Equity, Net Worth, Assets, Profitability.  
Acronyms : Return on Assets (ROA), Return on Equity (ROE), Return on Net Worth (RONW), Bombay  
Stock Exchange (BSE).  
.1 Prologue  
From financial perspective company assets’ sole purpose is to generate revenues and produce profits.  
Ratio helps both management and investors see how well the company can convert its investments in  
assets into profits. For this purpose the Return on Assets (ROA) ratio, often called the return on total  
assets, which is a profitability ratio, measures the net income produced by total assets during a period  
by comparing net income to the average total assets. The ROA ratio measures how efficiently a company  
can manage its assets to produce profits during a period. This ratio measures how effectively a company  
can earn a return on its investment in assets. In other words, ROA shows how efficiently a company  
can covert the money used to purchase assets into net income or profits. It signifies that a higher ratio  
is more favorable to investors because it shows that the company is more effectively managing its  
assets to produce greater amounts of net income. A positive ROA ratio usually indicates an upward  
profit trend as well. ROA is most useful for comparing companies in the same industry as different  
industries use assets differently. For instance, construction companies use large, expensive equipment  
while software companies use computers and servers.  
Every firm needs capital in order to meet its permanent or long-term financing arrangements for which  
it has to decide upon a suitable capital structure. Capital structure refers to the combination of debt  
and equity capital which a firm uses to finance its long-term operations. The ratio between debt and  
equity is named leverage. It has to be optimized as high leverage can bring a higher profit. The leverage  
can be used as an instrument to transfer wealth between investors i.e. from lenders to the shareholders.  
A high level of debt can artificially boost Return on Equity (ROE); after all, the more debt a company  
has, the less shareholders’ equity it has (as a percentage of total assets), and the higher its ROE is. It  
pays to invest in companies that generate profits more efficiently than their rivals. ROE can help investors  
distinguish between companies that are profit creators and those that are profit burners. By measuring  
how much earnings a company can generate from assets, ROE offers a gauge of profit-generating  
efficiency. ROE helps investors determine whether a company is a profit maker or an inefficient firm.  
Firms that do a good job of milking profit from their operations typically have a competitive advantage  
International Peer-Reviewed Journal  
a feature that normally translates into superior returns for investors. The relationship between the  
company’s profit and the investor’s return makes ROE a particularly valuable metric to examine.  
.1 Literature Review  
Theoretical and empirical research suggests that financial planner should plan optimal capital structure.  
In practice, financial management literature does not provide specified methodology for designing a  
firm’s optimal capital structure.  
.1.1 Excerpts from Review of Literature  
A number of research studies have been conducted regarding the choice of debt equity mix in the total  
capitalization of a firm in the International as well as Indian context. These studies have revealed the  
Return on Asset (ROA) after tax is negatively related to total debt equity ratio (Ferri and Jones, 1979;  
Myers and Majluf, 1984; Brigham and Gapenski, 1988; and Kakani and Reddy, 1996). Gorden (1962)  
observed that with the increase of size, return on investment was negatively related to debt-equity  
ratio. Mohanty (2003) in his paper “A Review of Research on the practices of Corporate Finance” found  
that leverage is negatively related with profitability.  
.1.2 Research Gap  
In most of the literature studied, it is seen that, major emphasis was given on:  
i) Components of capital structure,  
ii) The effects of capital structure on cost of capital, and  
iii) Determinants of capital structure.  
However, no serious and systematic efforts have been made by the researchers, so far in regard to  
identifying the relationship between the capital structure and companies performance. An in-depth  
and systematic study in this unexplored area is therefore undertaken in the present treatise.  
.1 Objectives of the Study  
The study specifies the following objectives:  
i) To analyse the components of Capital Structure and computation of Debt-to-Equity (D/E) ratio.  
ii) To determine the firm’s performance in terms of its Return on Assets (ROA) and Return on Net  
Worth (RONW).  
iii) To test the relationship between leverage and the profitability.  
iv) To draw suitable inferences from above findings.  
.2 Hypothesis of the Study  
Null Hypothesis (H ): There is no significant difference in the profitability between firms on the basis of  
their leverage.  
Alternative Hypothesis (H ): There is a significant difference in the profitability between firms on the  
basis of their leverage.  
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.3 Research Methodology  
A systematic and organized set of research methodologies has helped the researcher to achieve the  
research objectives. This study is purely an empirical and analytical study. The researcher has used  
multi-stage sampling technique for the purpose of this study. All financial figures have been obtained  
from audited annual reports of the respective companies. Further computation of ratios and analysis is  
carried on by the researcher using statistical software tools. The period of data used for the present  
study is the latest concluded Financial Year 2014-15. The data pertaining to number of sample  
companies is obtained directly from BSE officials.  
.3.1 Multi-stage Sampling  
3.21 lakh companies were registered with Ministry of Corporate Affairs in India as on May 31, 2013.  
The total number of companies listed on BSE is 5,410 as on 31 December, 2015 out of which shares  
of 3,960 companies are available for trade on BSE, amongst them 2,501 are actively traded on BSE.  
The Securities traded on BSE have been classified into various groups amongst them BSE “A” Group  
is the most tracked class of scrips/stocks. In this “A” Group 235 companies find its place. The S&P  
BSE SENSEX (S&P Bombay Stock Exchange Sensitive Index), also-called the BSE 30 or simply the  
SENSEX, is a free-float market-weighted stock market index of 30 well-established and financially  
sound companies listed on Bombay Stock Exchange. The 30 component companies which are some  
of the largest and most actively traded stocks, are representative of various industrial sectors of the  
Indian economy. SENSEX is thus regarded as the pulse of the domestic stock markets in India.  
Within the 30 companies from the SENSEX industry-wise groups are formed and within each industry  
where there exist two or more companies, two such companies are selected through random sampling  
technique using formula in Excel by way of selection of cells. Thus by following multi-stage sampling  
process the final sample of five industries such as IT Consulting & Software, Oil & Gas Exploration &  
Production, Pharmaceuticals, Cars & Utility Vehicles and 2/3 Wheelers were used. Two sample  
companies are selected from within each of the five industries. Thus the total number of sample  
companies considered for this study is ten. The researcher has used suitable statistical tools in order  
to analyse the collated data.  
Banking companies excluded from the study due to its peculiar nature of capital structure as well as  
asset structure.  
.3.2 Identification of Interacting Variables for the Study  
In order to abridge the research gap in the appropriate area identified earlier, especially to establish  
relationship between profitability Vs degree of financial leverage in the capital structure, the researcher  
has incorporated return on assets, return on net-worth, and debt-equity ratio, besides the relevant  
variables considered by the previous researchers.  
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.1 Data Analysis  
Table 1: Computation of ROA, RONW and D/E Ratios  
Source: Computed by the Researcher  
Note :  
Average Total Assets = (Opening + Closing)/2  
Also while calculating value of Total Assets, figure of Current Liabilities is not deducted from  
Current Assets figure. Hence, gross working capital is taken into consideration.  
.2 Findings  
On the basis of the above analysis it can be inferred that with increase in debt in the capital structure  
the profitability increases in case of two out of the select five industries (in 40% of the cases) i.e. in IT  
Consulting & Software, and Cars & Utility Vehicles whereas the profitability is rather low with increase  
of debt in the capital structure in case of three out of the select five industries (in 60% of the cases) i.e.  
in Oil & Gas Exploration & Production, Pharmaceuticals, and 2/3 Wheelers.  
.1 Results of Hypothesis Testing  
To test the relationship between leverage and the profitability.  
.1.1 Statistical Tool  
Karl Pearson’s Coefficient of Correlation “r” is used for finding correlation coefficient between two  
variables. Pearson’s correlation coefficient is the test statistics that measures the statistical relationship,  
or association, between two continuous variables. The + and – signs are used for positive and negative  
correlation respectively.  
International Peer-Reviewed Journal  
The following table shows the results of hypothesis testing.  
Table 2 : Results of Hypothesis Testing  
.1.2 Inference  
Here the correlation coefficient as a statistical tool is used to measure the mutual relationship between  
the two variables profitability and capital structure for which the following two hypotheses are tested.  
Correlation between Debt-Equity Ratio and ROA Ratio  
Correlation between Debt-Equity Ratio and RONW Ratio  
r = -0.62  
r = -0.56  
Since -0.75 < r <= -0.50 it means there exists a Moderate Degree Negative Correlation.  
Further, in order to assess the correlation between profitability and debt in the capital structure the  
following two hypotheses are tested.  
Correlation between Debt and ROA Ratio  
Correlation between Debt and RONW Ratio  
r = -0.47  
r = -0.43  
Since -0.50 < r < 0 it means there exists a Low Degree Negative Correlation.  
The result of hypotheses testing indicates that there exists a Negative Correlation between the  
study variables.  
.1 Research Implications  
The purpose of the study was to see whether profitability have any correlation with company’s leverage.  
The present study based on hypothesis that leverage variables can influence profitability and thus  
result in increase the returns on shareholders’ funds in the context of select industries in India revealed  
that shareholders’ returns vary significantly with significant variation in firm’s debt levels. The results of  
hypothesis testing reconfirms the findings made by Ferri and Jones, 1979; Myers and Majluf, 1984;  
Brigham and Gapenski, 1988; Kakani and Reddy, 1996; and Mohanty, 2003 that leverage is negatively  
related with profitability.  
To find companies with a competitive advantage, investors can use the ROEs of companies within the  
same industry. Some industries tend to have higher returns on equity than others. There exist inter-  
industry differences in the capital structure and profitability of Indian firms. As a result, comparisons of  
returns on equity are generally most meaningful among companies within the same industry, and the  
definition of a “high” or “low” ratio should be made within this context. As per this study conducted on  
the industrial corporations in India it can be concluded that there could not be a uniform ROA and ROE  
which will suit the requirements of investors in all the companies. Inter-industry variations must be  
given due importance.  
The present study also throws light on the pattern of sources of funds sourced by the companies  
analyzed here and it shows an increasing trend towards internal sources in their capital structure.  
Firms are more conservative in its reliance on debt funds. Borrowing is thus assumed lesser share in  
the capital structure.  
International Peer-Reviewed Journal  
.1 Epilogue  
The findings of this research study offer both theoretical and managerial contributions to the literature  
of corporate finance. Levered companies spend a large sum of money on expenditure which minimize  
the wealth of the firm and thus necessitates financial control. Increase in debt levels does not contain  
always good news to the equity investors as high level of debt does not automatically boost Return on  
Equity (ROE). It needs judicious use of finance with a proper vision by the finance personnel.  
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Associate Professor in Commerce, St. Xavier’s College (Autonomous), CST, Mumbai - 400 001. E-  
mail id: [email protected]