RESEARCH HORIZONS

Magazine 2016

International Peer-Reviewed Journal

RESEARCH HORIZONS, VOL. 6 JULY 2016

COMMERCE

ANALYZING THE CORPORATE CAPITAL STRUCTURE AND ITS

IMPACT ON FIRM PERFORMANCE IN THE INDIAN CONTEXT

Arvind Dhond

ABSTRACT

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

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RESEARCH HORIZONS, VOL. 6 JULY 2016

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

following:

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

RESEARCH HORIZONS, VOL. 6 JULY 2016

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

RESEARCH HORIZONS, VOL. 6 JULY 2016

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.

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RESEARCH HORIZONS, VOL. 6 JULY 2016

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.

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.1 Epilogue

RESEARCH HORIZONS, VOL. 6 JULY 2016

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]

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