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IJCOMA
23,4 The impact of capital structure
on performance
An empirical study of non-financial
354 listed firms in Pakistan
Received 10 November 2011 Nadeem Ahmed Sheikh
Revised 26 February 2012 Institute of Management Sciences, Bahauddin Zakariya University,
Accepted 6 March 2012 Multan, Pakistan, and
Zongjun Wang
School of Management, Huazhong University of Science and Technology,
Wuhan, People’s Republic of China

Abstract
Purpose – The purpose of this paper is to investigate whether capital structure affects the
performance of non-financial firms in Pakistan.
Design/methodology/approach – Panel econometric techniques namely pooled ordinary least
squares (OLS), fixed effects, and random effects were used to investigate the impact of capital structure
on performance of non-financial firms listed on the Karachi Stock Exchange Pakistan during 2004-2009.
Findings – Empirical results indicate that all measures of capital structure (i.e. total debt ratio, long
and short-term debt ratio) are negatively related to return on assets in all regressions. Moreover, total
debt ratio and long-term debt ratio are negatively related to market-to-book ratio under the pooled OLS
model, whereas these measures are positively related to market-to-book ratio under the fixed effects
model. Short-term debt ratio is positively related to market-to-book ratio in all regressions, however
the relationship is found insignificant. A negative relationship between capital structure and
performance indicates that agency issues may lead the firms to use higher than appropriate levels of
debt in their capital structure. This overleveraging may increase the lenders’ influence which in turn
limits the managers’ ability to manage the operations effectively, hence negatively affecting the firm
performance.
Practical implications – Empirical results indicate that capital structure has material effects on
firm performance. Thus, corporate managers should consider the impact of leverage on performance
before adjusting the debt levels. Moreover, lenders should tenderly inflict the debt covenants
considering their impact on firm performance. Finally, investors should consider the firm’s debt level
before making investment decisions.
Originality/value – This may probably be the first study that explores the impact of capital
structure on performance using the most recent data set of Pakistani firms. Moreover, this paper lays
some groundwork upon which a more detailed evaluation of Pakistani firms’ capital structures and
their impact on performance could be based.
Keywords Pakistan, Capital structure, Firm performance, Non-financial firms
Paper type Research paper

International Journal of Commerce

and Management
Vol. 23 No. 4, 2013
pp. 354-368
q Emerald Group Publishing Limited
1056-9219
The authors are thankful to Dr Abbas J. Ali (the Editor) and two anonymous reviewers for their
DOI 10.1108/IJCoMA-11-2011-0034 invaluable comments and suggestions. All these make this article more valuable and readable.
Introduction Impact of
An important decision which firms’ managers must make relates to the relative capital structure
amounts of debt and equity that they should use in their capital structure. In a seminal
study, Modigliani and Miller (1958) proposed that managers should stop worrying on performance
about the proportion of debt and equity securities because in perfect capital markets
(no taxes, no transaction costs, and symmetric information, etc.) any combination of
debt and equity securities is as good as another. Although their “debt irrelevance 355
theorem” is based on restrictive assumptions which do not hold in the real world, when
these assumptions are removed then the choice of debt-equity becomes an important
value determining factor. For instance, by relaxing the assumption of taxes, Modigliani
and Miller (1963) proposed that firms should use maximum debt in their capital
structure because of tax deductible interest payments. Thus, maximum use of debt has
a positive impact on firm performance. Moreover, Jermias (2008) observed that debt
financing not only offers the benefit of tax advantage to cost leaders but also accords
increased efficiency due to constraints imposed by the debtholders. Alternatively,
Simerly and Li (2000) argued that the use of debt in the firm’s capital structure
introduces an external constituency which has a short-term orientation. This
orientation can impose covenants that limit the strategic choice of managers, hence,
affecting their ability to carry out critical strategic decisions. Moreover, they observed
that debt holders’ constraints limit the managers’ ability to be creative and innovative,
which is critical for a firm to thrive and succeed. On the other hand, Phillips and
Sipahioglu (2004) and Qureshi (2007) observed that low debt levels in a firm’s capital
structure plays a dominant role in maximizing the firm value.
The literature on the relationship between capital structure and firm performance
is immense and mainly refers to developed countries, however, empirical evidence
yields contradictory and inconsistent results (Berger and Bonaccorsi di Patti, 2006;
Chathoth and Olsen, 2007; Jermias, 2008; Margaritis and Psillaki, 2010; Phillips and
Sipahioglu, 2004; Singh and Faircloth, 2005). Alternatively, empirical research to
understand the impact of capital structure on performance has received much less
attention in developing countries (Abor, 2007; Ebid, 2009; Krishnan and Moyer, 1997;
Kyerboah-Coleman, 2007; Lin and Chang, 2011; Majumdar and Chhibber, 1999).
In particular, little is empirically known about the impact of capital structure on
performance in Pakistan. Notably, no significant study is yet published that has
investigated the affect of capital structure on performance using the data of Pakistani
firms, at least to the extent of the authors’ knowledge. Thus, a gap in the literature and
inconclusive empirical findings are a few reasons that have evoked the need for this
empirical investigation.
The primary objective of this paper is to investigate whether three key measures of
capital structure such as total debt ratio, long and short-term debt ratio influence the
performance of Pakistani firms. Based on data availability, two performance measures
such as return on assets (accounting-based) and market-to-book ratio (market-based)
were used as dependent variables in this study. Empirical results indicate that capital
structure is negatively related to performance. This finding is incongruent with the
irrelevance proposition made by Modigliani and Miller (1958) suggesting that the
choice between debt and equity has no material effects on firm performance. As far as
control variables are concerned, asset tangibility is negatively, whereas firm size and
growth are positively related to performance. In sum, empirical results indicate that
IJCOMA capital structure has material effects on firm performance. Therefore, corporate
23,4 managers should consider the effects of leverage on performance before adjusting the
debt levels. Although, lenders can confine the opportunistic behavior of managers by
imposing stringent debt covenants, these restrictions can limit the managers’ ability to
be creative and innovative, which is crucial for a firm to thrive and succeed. Therefore,
they should carefully impose the restrictions by considering their impact on
356 performance. Investors should consider the debt levels in a firm’s capital structure
before making investment decisions.
The rest of the paper proceeds as follows. The next section presents the review of
literature regarding the impact of capital structure on performance. It is then followed
by the empirical part which describes the data, variables, and research methodology.
The next section presents the results and discussion of empirical findings. Finally, the
last section provides the conclusions of the study.

Review of literature
Capital structure management involves the selection of debt and equity securities in a
way that will maximize the value of the firm. Ever since Modigliani and Miller (1958)
proposed that capital structure is irrelevant in determining the firm value, the theory of
capital structure has been investigated extensively. For instance, Jensen and Meckling
(1976) opposed the debt irrelevance theorem by arguing that stringent debt covenants
associated with the use of debt might confine the manager’s ability to operate freely,
which in turn affects firm performance. Ever since Jensen and Meckling recognized
that capital structure influences firm performance, studies have been conducted to
estimate the relationship between capital structure and performance. However,
empirical findings remain unclear whether debt is good or bad. Arguments and
empirical findings have gone both ways. Some researchers have argued that debt has a
positive effect on performance, whereas, other researchers oppose such claims by
arguing that debt has a negative effect on performance.
For instance, Jensen and Meckling (1976) argued that conflicts between shareholders
and managers arise because managers hold less than 100 percent of the residual
claim. Consequently, they do not capture the entire gain from their profit enhancement
activities, but they do bear the entire cost of these activities. However, the use of
debt may increases the managers’ share of equity and mitigate the loss that arises
because of conflicts between managers and shareholders (Harris and Raviv, 1991).
In addition, Jensen (1986) suggests that debt reduces the agency costs of free cash flow
by reducing the cash flow available for spending at the discretion of managers.
Grossman and Hart (1982) suggest that if bankruptcy is costly for managers, perhaps
because they lose the benefits of control or reputation, then debt can create an incentive
for managers to work harder, consume fewer perquisites, and make better investment
decisions, etc. These findings indicate that despite the threat of financial distress,
dangerously high debt levels can add value by putting the firm on a diet deal. In a study
on microfinance institutions in Ghana, Kyerboah-Coleman (2007) found that highly
leveraged microfinance institutions perform better by reaching out to a larger clientele
base and enjoying scale economies. Similarly, Berger and Bonaccorsi di Patti (2006)
using the data of firms from the US banking industry found that higher leverage or
lower equity capital ratio is associated with higher profit efficiency. Jermias (2008)
analyzed the data of US manufacturing firms. He observed that debt financing not only
offers the benefit of tax shields to cost leaders but also accords increased efficiency Impact of
due to constraints imposed by the debtholders. Margaritis and Psillaki (2010) using the capital structure
data of French firms from low-and-high growth industries have shown that higher
leverage is associated with improved efficiency. on performance
Alternatively, Gleason et al. (2000) using the data of retailers from 14 European
countries found that capital structure negatively affect firm performance. Balakrishnan
and Fox (1993) argued that high debt levels increase the managers’ risk aversion and 357
reduce their willingness to invest in risky but profitable projects. In a study on Indian
firms, Majumdar and Chhibber (1999) have shown that debt-equity ratio negatively
affects the corporate performance. Moreover, they observed that firm size, diversity,
advertising, inventory, and liquidity are positively, whereas age, excise duty, time,
and industrial grouping are negatively related to corporate performance. Singh and
Faircloth (2005) using the data of US manufacturing firms observed that higher
leverage adversely influences the future investment in R&D which may in turn leads to
negative impact on long-term operating performance and future growth opportunities.
Abor (2007) has analyzed the data of small and medium enterprises in Ghana and
South Africa. He observed that all measures of capital structure are negatively related
to return on assets, in the case of Ghanaian firms. However, in the case of South-African
firms, short-term debt and trade-credits are positively, whereas total debt and
long-term debt are negatively related to return on assets. Ebid (2009) analyzed the data
of Egyptian listed firms. He showed that short-term debt and total debt are negatively
related to return on assets. Moreover, he has shown an insignificant relationship
between all measures of capital structure and return on equity, as well as gross profit
margin. Simerly and Li (2000) analyzed the effects of leverage on performance under
varying degrees of environmental dynamism. They proposed that leverage produces
either a positive or negative impact on firm performance depending on whether
the firms are in a stable or dynamic environment. In addition, they argued that the use
of debt introduces an external constituency which has a short-term orientation. This
orientation can impose covenants that limit the strategic choices of managers, hence,
affecting their ability to carry out critical strategic decisions. Chathoth and Olsen (2007)
analyzed the data of 48 firms in the US restaurant industry in order to estimate the
impact of environmental risk, corporate strategy, and capital structure on corporate
performance. They found that variables representing the environmental risk, corporate
strategy, and capital structure explain a significant variance in firm performance.
Some empirical studies have shown no significant relationship between capital
structure and firm performance. For instance, Phillips and Sipahioglu (2004) tested the
debt irrelevance theorem of Modgliani and Miller using the data of 43 UK quoted
organizations which possess an interest in owning and managing hotels. They
observed that no significant relationship exists between the level of debt in the capital
structure and firm performance. Krishnan and Moyer (1997) analyzed the data of
81 corporations from Asia (i.e. Hong Kong, Malaysia, Singapore, and Korea). They
found that both financial performance and capital structure are influenced by the
country of origin. In addition, they observed that corporations in Hong Kong have
significantly higher returns on equity and invested capital than corporations from
other countries. Corporations from Korea have significantly higher leverage than
corporations from other countries. Finally, they showed that leverage itself does not
seem to affect corporate performance.
IJCOMA In sum, it is difficult to draw any conclusion because empirical findings are not only
23,4 inconsistent but also equivocal. Thus, failure of research to provide a consistent and
systematic relationship between capital structure and firm performance is an
important reason that has necessitated the need for this empirical study.

Data, variables and research methodology

358 Data
This study investigates whether capital structure affected the performance of
non-financial firms listed on the Karachi Stock Exchange (KSE) Pakistan during
2004-2009. The data were taken from the publications of the State Bank of Pakistan
(SBP) entitled Balance Sheet Analysis of Joint Stock Companies Listed on KSE.
Notably, this is mandatory for public limited companies to prepare their financial
statements in accordance with the approved accounting standards as applicable in
Pakistan. Approved accounting standards are comprised of International Financial
Reporting Standards issued by the International Accounting Standards Board,
as notified under the Companies Ordinance 1984. Although SBP has compiled the data
for reasons other than those of this research, this data set provides useful information
and allows for calculation of many variables that are known to be relevant from studies
of firms in developed countries. Data relevant to market price of common shares were
taken from the annual diaries of KSE.
Initially all 411 non-financial firms listed on KSE during 2003-2009 were included in
the sample; however, observations that did not have a complete record of information
were deleted from the study. Moreover, one year data is lost because capital
expenditures are estimated as the one year variation in net fixed assets. Therefore, the
final sample set consists of a balanced panel of 240 firms over a period of six years from
2004 to 2009. Firms included in the sample belong to eight distinct industrial groups
namely cement, chemicals, engineering, fuel and energy, paper and board, sugar and
allied, textile and other textile, and miscellaneous. Classification of sample firms in
relation to their affiliation with different industrial groups is presented in Table I.

Variables
Variables used in this study and their definitions are largely adopted from existing
literature in order to make a meaningful comparison with prior empirical studies.
Based on data availability, two measures of firm performance such as return on assets
(accounting-based) and market-to-book ratio (market-based) were used as dependent

Industry/sector No. of firms Proportion of firms (%)

Cement 14 5.83
Chemical 25 10.42
Engineering 26 10.83
Fuel and energy 15 6.25
Table I. Paper and board 07 2.92
Proportion of firms Sugar and allied 23 9.59
in relation to their Textile and other textile 92 38.33
affiliation with different Miscellaneous 38 15.83
industrial groups Total 240 100
variables in this study. Alternatively, key explanatory variables include total debt Impact of
ratio, long and short-term debt ratio. In addition to key explanatory variables, we
included some standard control variables that may affect the firm performance such as
capital structure
firm size, asset tangibility, and growth. Definitions of these variables are listed in on performance
Table II.

Research methodology 359

This study used panel data procedures because sample contained data across firms
and over time. Three panel econometric techniques, namely pooled ordinary least
squares, fixed effects, and random effects, were used to estimate the relationship
between key explanatory variables and performance measures. In the simplest case in
which there are no firm-specific and time-specific effects, the pooled ordinary least
squares method is most appropriate. Alternatively, fixed effects estimation model
allows the intercept for each firm to vary, but restricts the slope parameters to be
constant across all firms and time periods. The rationale behind the random effects
model is that, unlike the fixed effects model, the variation across entities is assumed to
be random and uncorrelated with the explanatory variables included in the model. The
study also used the Hausman (1978) specification test to choose which estimation
model either the fixed effects or the random effects best explain our estimation.
Accordingly, the basic regression is expressed as:
yit ¼ a þ X 0it b þ uit i ¼ 1; . . . ; 240; t ¼ 1; . . . ; 6
where i stands for the ith cross-sectional unit and t for the tth time period. yit is
performance measure for the ith firm at time t, and a is the intercept. X 0 it is a 1 £ K
vector of observations on K explanatory variables for the ith firm in the tth period, b is
a K £ 1 vector of parameters, uit is a disturbance term and is defined as:
uit ¼ mi þ vit
where mi denotes the unobservable individual effects and nit denotes the remainder
disturbance. The description of three estimation models (i.e. pooled OLS, fixed effects and
random effects) is given below:

Variable Definition

Dependent variables
Return on assets (ROAit)
Market-to-book ratio (MBRit)
Key explanatory variables
Total debt ratio (TDRit)
Long-term debt ratio (LDRit)
Short-term debt ratio (SDRit)
Control variables
Size (SIZEit)
Asset tangibility (ATNGit)
Growth (GROWit)
Ratio of profit before taxes to total assets
Ratio of average of the high and low market price per share for
the year to average book value per share
Ratio of total debt to total assets
Ratio of long-term debt to total assets
Ratio of short-term debt to total assets
Natural logarithm of sales
Ratio of tangible assets (the sum of net fixed assets and
inventories) to total assets
Ratio of capital expenditures to total assets. Capital
expenditures are estimated as the one year variation in net fixed Table II.
assets Definition of variables
IJCOMA X
n
Performanceit ¼ b0 þ b1 Leverageit þ b2 Control ijt þ 1it
23,4 j¼1

X
n
Performanceit ¼ b0i þ b1 Leverageit þ b2 Control ijt þ mit
360 j¼1

X
n
Performanceit ¼ b0 þ b1 Leverageit þ b2 Control ijt þ 1i þ mit
j¼1

where Performanceit is one of the two measures of performance for the ith firm at
time t, Leverageit is one of the three key debt ratios for the ith firm at time t, Controlit is the
jth control variables for the ith firm at time t, b0 is the intercept, 1it is the random error term
for the ith firm at time t, b0i is the intercept for the ith firm, mit is the random error term for
the ith firm at time t, 1i is the error component for the ith firm.

Empirical results
Descriptive statistics and correlation of variables
Table III presents the descriptive statistics of variables used in the study. The mean
return on assets is 6.37 percent indicating the firms’ ability to generate income by using
their total assets. The mean market-to-book ratio is 1.40. In particular, the average total
debt ratio is 57.72 percent which indicates the proportion of assets financed with total
liabilities. On average, the proportion of total assets financed with long and short-term
debt is 12.32 and 45.39 percent, respectively. These averages present a remarkable
difference that exists between the capital choices of Pakistani firms and firms
in developed countries. Moreover, the greater dependence of Pakistani firms on
short-term debt confirms the findings of Demirguc-Kunt and Maksimovic (1999)
suggesting that firms in developing countries have substantially lower amounts of
long-term debt.
The data were tested for multicollinearity before estimating the coefficients. The
results are presented in Table IV which shows that the pair-wise correlation of
variables generally does not appear to indicate any concern over multicollinearity
problem in estimating the regression.

Variable Observations Mean SD Minimum Maximum

ROAit 1,440 0.06371 0.11564 21.0018 1.24077

MBRit 1,440 1.40111 1.91620 0.04347 34.8181
TDRit 1,440 0.57722 0.20026 0.01390 0.99984
LDRit 1,440 0.12328 0.12829 0.00000 0.73750
SDRit 1,440 0.45394 0.17525 0.01390 0.99984
SIZEit 1,440 7.55684 1.58525 1.09861 13.4869
Table III. ATNGit 1,440 0.68678 0.18733 0.04203 0.98409
Descriptive statistics GROWit 1,440 0.05540 0.12118 20.9695 0.72291
 Impact of
Variable ROAit MBRit TDRit LDRit SDRit SIZEit ATNGit GROWit
capital structure
ROAit 1 on performance
MBRit 0.37 * * * 1
TDRit 2 0.41 * * * 20.05 * * 1
LDRit 2 0.28 * * * 20.1 * * * 0.50 * * * 1
SDRit 2 0.26 * * * 0.009 0.77 * * * 2 0.15 * * * 1 361
SIZEit 0.32 * * * 0.22 * * * 0.12 * * * 0.04 * 0.10 * * * 1
ATNGit 2 0.30 * * * 20.14 * * * 0.29 * * * 0.38 * * * 0.05 * * 2 0.16 * * * 1
GROWit 0.02 0.02 0.01 0.22 * * * 20.14 * * * 0.02 0.25 * * * 1
Table IV.
Note: Significance at: *10, * *5 and * * *1 percent levels Correlation matrix

Regression results
During the data analysis process, a total of 18 equations were estimated in order to
analyze the impact of three key explanatory variables on two performance measures.
Empirical results shown in Table V indicate that the total debt ratio is negatively related
to return on assets in all regressions. Alternatively, firm size and growth are positively,
whereas asset tangibility is negatively related to return on assets. Results of Hausman
specification test indicate that the null hypothesis cannot be rejected at any conventional
level of significance. Results presented in Table VI show that the total debt ratio is
negatively related to market-to-book ratio under the pooled OLS model. Alternatively, it
is positively related to market-to-book ratio under the fixed effects and the random
effects model. Under the pooled OLS model, firm size is positively, whereas under the
fixed effects model it is negatively related to market-to-book ratio. Finally, asset
tangibility is negatively, whereas growth is positively related to market-to-book ratio in
all regressions. Results of the Hausman specification test indicate that the null
hypothesis is rejected and we may be better off using the fixed effects model.
Results reported in Table VII indicate that the long-term debt ratio is negatively
related to return on assets in all regressions. Firm size and growth are positively,
whereas asset tangibility is negatively related to return on assets. Results of the

Variable Pooled OLS Fixed effects Random effects

C 0.0604 * * * (3.5927) 0.1244 * * * (3.1529) 0.0828 * * * (3.4055)

TDRit 20.2410 * * * (2 18.093) 2 0.2172 * * * (29.5101) 20.2266 * * * (2 13.330)
SIZEit 0.0259 * * * (15.944) 0.0210 * * * (4.8438) 0.0242 * * * (10.017)
ATNGit 20.0824 * * * (2 5.5578) 2 0.1419 * * * (24.9848) 20.1082 * * * (2 5.5028)
GROWit 0.0508 * * (2.3768) 0.0559 * * * (2.9744) 0.0525 * * * (2.8985)
R2 0.3313 0.6658 0.1959
Adjusted R 2 0.3295 0.5979 0.1937
SE of regression 0.0946 0.0733 0.0733
F-statistic 177.80 9.8077 87.447
Prob. (F-statistic) 0.0000 0.0000 0.0000
Hausman specification
test Table V.
x 2 (df 4) 4.6305 Prob. 0.3273 The effect of total debt
ratio (TDRit) on return on
Notes: Significance at: *10, * *5 and * * *1 percent levels; t-statistic given in parentheses assets (ROAit)
IJCOMA
Variable Pooled OLS Fixed effects Random effects
23,4
C 0.4947 (1.5015) 2.4938 * * * (4.1603) 1.3888 * * * (3.0123)
TDRit 20.4709 * (2 1.8055) 1.0932 * * * (3.1515) 0.6119 * * (2.0591)
SIZEit 0.2537 * * * (7.9595) 20.1533 * * (2 2.3237) 0.0615 (1.3178)
ATNGit 21.1327 * * * (2 3.8992) 20.8539 * * (2 1.9742) 21.2141 * * * (2 3.4376)
362 GROWit 0.6999 * (1.6706) 0.3875 (1.3572) 0.4945 * (1.7662)
R2 0.0670 0.7193 0.0119
Adjusted R 2 0.0644 0.6623 0.0091
SE of regression 1.8534 1.1134 1.1236
F-statistic 25.767 12.616 4.3256
Table VI. Prob. (F-statistic) 0.0000 0.0000 0.0017
The effect of total debt Hausman specification test
ratio (TDRit) x 2 (df 4) 30.4472 Prob. 0.0000
on market-to-book
ratio (MBRit) Notes: Significance at: *10, * *5 and * * *1 percent levels; t-statistic given in parentheses

Variable Pooled OLS Fixed effects Random effects

C 20.0062 (2 0.3434) 0.0308 (0.7852) 0.0150 (0.5894)

LDRit 20.2339 * * * (2 10.169) 2 0.0907 * * * (22.9839) 20.1461 * * * (2 5.6983)
SIZEit 0.0224 * * * (13.026) 0.0187 * * * (4.1613) 0.0207 * * * (8.0582)
ATNGit 20.1123 * * * (2 6.9861) 2 0.1487 * * * (25.0355) 20.1384 * * * (2 6.6045)
GROWit 0.1135 * * * (4.9236) 0.0854 * * * (4.4142) 0.0918 * * * (4.9040)
R2 0.2340 0.6432 0.1121
Adjusted R 2 0.2319 0.5707 0.1096
SE of regression 0.1013 0.0757 0.0760
F-statistic 109.62 8.8741 45.311
Prob. (F-statistic) 0.0000 0.0000 0.0000
Hausman specification
Table VII. test
The effect of long-term x 2 (df 4) 16.5377 Prob. 0.0024
debt ratio (LDRit) on
return on assets (ROAit) Notes: Significance at: *10, * *5 and * * *1 percent levels; t-statistic given in parentheses

Hausman specification test indicate that the random effects model is rejected in favor
of the fixed effects model. Results shown in Table VIII indicate that the long-term debt
ratio is negatively related to market-to-book ratio under the pooled OLS model. On the
other hand, long-term debt ratio is positively related to market-to-book ratio under the
fixed effects model. Under the pooled OLS estimation model, firm size is positively,
whereas it is negatively related to market-to-book ratio under the fixed effects model.
Finally, asset tangibility is negatively, whereas growth is positively related to
market-to-book ratio in all regressions. Results of Hausman specification test indicate
that the null hypothesis is rejected and we may be better off using the fixed effects
model.
Empirical results shown in Table IX indicate that the short-term debt ratio is negatively
related to return on assets in all regressions. Firm size and growth are positively,
whereas asset tangibility is negatively related to return on assets. Results of
 Impact of
Variable Pooled OLS Fixed effects Random effects
capital structure
C 0.2607 (0.7893) 2.9092 * * * (5.0189) 1.5805 * * * (3.5297) on performance
LDRit 21.2960 * * * (2 3.0877) 0.9033 * * (2.0171) 0.4890 (1.2005)
SIZEit 0.2539 * * * (8.0731) 20.1372 * * (2 2.0713) 0.0727 (1.5672)
ATNGit 20.9764 * * * (2 3.3262) 20.8650 * * (2 1.9877) 21.1806 * * * (2 3.3327)
GROWit 0.9389 * * (2.2312) 0.2106 (0.7385) 0.3895 (1.3930) 363
R2 0.0710 0.7180 0.0102
Adjusted R 2 0.0684 0.6607 0.0074
SE of regression 1.8494 1.1161 1.1271
F-statistic 27.444 12.531 3.7160
Prob. (F-statistic) 0.0000 0.0000 0.0051 Table VIII.
Hausman specification test The effect of long-term
x 2 (df 4) 32.2756 Prob. 0.0000 debt ratio (LDRit) on
market-to-book ratio
Notes: Significance at: *10, * *5 and * * *1 percent levels; t-statistic given in parentheses (MBRit)

Variable Pooled OLS Fixed effects Random effects

C 0.0735 * * * (4.0398) 0.0749 * (1.9025) 0.0736 * * * (2.8196)

SDRit 20.1813 * * * (211.739) 20.1543 * * * (26.8150) 20.1659 * * * (28.9552)
SIZEit 0.0230 * * * (13.514) 0.0221 * * * (4.9912) 0.0226 * * * (8.7444)
ATNGit 20.1511 * * * (210.131) 20.1622 * * * (25.6051) 20.1575 * * * (27.7513)
GROWit 0.0331 (1.4438) 0.0529 * * * (2.7348) 0.0479 * * (2.5562)
2
R 0.2508 0.6540 0.1386
Adjusted R 2 0.2487 0.5837 0.1362
SE of regression 0.1002 0.0746 0.0745
F-statistic 120.09 9.3039 57.732
Prob. (F-statistic) 0.0000 0.0000 0.0000
Hausman specification test Table IX.
x 2 (df 4) 1.6015 Prob. 0.8085 The effect of short-term
debt ratio (SDRit) on
Notes: Significance at: *10, * *5 and * * *1 percent levels; t-statistic given in parentheses return on assets (ROAit)

Hausman specification test indicate that the null hypothesis cannot be rejected at any
conventional level of significance. Results presented in Table X show that the short-term
debt ratio is positively related to market-to-book ratio but the relationship is highly
insignificant. Under the pooled OLS estimation model, firm size is positively, whereas it is
negatively related to market-to-book ratio under the fixed effects model. Finally, asset
tangibility is negatively, whereas growth is positively related to market-to-book ratio.
Results of Hausman specification test indicate that the null hypothesis is rejected and we
may be better off using the fixed effects model.
In summary, all measures of capital structure (i.e. total debt ratio, long and short-term
debt ratio) are negatively related to return on assets. Moreover, total debt ratio and
long-term debt ratio are negatively related to market-to-book ratio under the pooled OLS
model, whereas these measures are positively related to market-to-book ratio under the
fixed effects model. Short-term debt ratio is positively related to market-to-book ratio,
IJCOMA
Variable Pooled OLS Fixed effects Random effects
23,4
C 0.4117 (1.2218) 2.8345 * * * (4.8037) 1.4859 * * * (3.2141)
SDRit 0.0327 (0.1144) 0.5209 (1.5361) 0.3574 (1.1803)
SIZEit 0.2425 * * * (7.6702) 20.1546 * * (2 2.3286) 0.0643 (1.3710)
ATNGit 21.3118 * * * (2 4.7510) 20.7592 * (2 1.7524) 21.1074 * * * (2 3.1634)
364 GROWit 0.7675 * * (1.8062) 0.3582 (1.2356) 0.4881 * (1.7164)
R2 0.0649 0.7176 0.0099
Adjusted R 2 0.0622 0.6602 0.0072
SE of regression 1.8555 1.1169 1.1243
F-statistic 24.899 12.506 3.6097
Table X. Prob. (F-statistic) 0.0000 0.0000 0.0061
The effect of short-term Hausman specification test
debt ratio (SDRit) x 2 (df 4) 23.1827 Prob. 0.0001
on market-to-book
ratio (MBRit) Notes: Significance at: *10, * *5 and * * *1 percent levels; t-statistic given in parentheses

but the relationship is highly insignificant in all regressions. As far as control variables
are concerned, firm size is positively related to return on assets. Moreover, firm size is
positively related to market-to-book ratio under the pooled OLS estimation model, but it
is negatively related to market-to-book ratio under the fixed effects model. Finally, asset
tangibility is negatively, whereas growth is positively related to both measures of firm
performance in all regressions.

Discussion on empirical results

Financing behavior of Pakistani firms
Descriptive statistics shown in Table III indicates the striking difference that exists
between the firms’ long and the short-term debt. This difference in long-term versus
short-term debt indicates that Pakistani firms usually prefer short rather than long-term
debt. This finding is congruent with Sheikh and Wang (2011) suggesting that Pakistani
firms prefer to use short-term debt either because of a limited and undeveloped bond
market in the country or due to high cost long-term bank debt. Notably, in Pakistan the
non-securities market is much more dominant over the securities market. The
non-securities market is comprised of well established commercial banks, development
finance institutions, and specialized banks/institutions for industry and small
businesses. However, these institutions (in particular privatized commercial banks)
prefer to extend short-term loans on favorable terms compared to long-term risky loans
to firms because of political and economic instability in the country. Owing to these
reasons, firms turn to short-term debt even when financing their long-term investment.

Discussion on empirical results

Empirical results indicate that all measures of capital structure (i.e. total debt ratio,
long and short-term debt ratio) are negatively related to return on assets. Moreover,
total debt ratio and long-term debt ratio are negatively related to market-to-book ratio
under the pooled OLS estimation model. However, these measures of capital structure
are positively related to market-to-book ratio under the fixed effects model. Although
short-term debt ratio is positively related to market-to-book ratio, the relationship is
found insignificant. The negative relationship between capital structure and
performance is consistent with the findings of Abor (2007), Ebid (2009), Gleason et al. Impact of
(2000), Majumdar and Chhibber (1999), and Singh and Faircloth (2005). In addition, capital structure
control variables such as firm size and growth are positively, whereas asset tangibility
is negatively related to firm performance. on performance
These findings have some important implications. First, empirical results indicate
that capital structure has material effects on firm performance. A negative relationship
between capital structure and performance is incongruent with the “debt irrelevance 365
theorem” of Modigliani and Miller (1958), suggesting that the choice between debt and
equity has no material effects on firm performance. Second, agency explanations
suggest that firms choose higher debt levels in order to mitigate the agency problems
between managers and shareholders, which in turn enhance the value of the firm.
However, Pakistani firms use higher debt levels than are appropriate. Therefore, this
overleveraging may increase the lenders’ influence through infliction of stringent debt
covenants, which in turn limit the managers’ ability to operate freely, thereby
negatively affecting the firm performance. In addition, Pakistani firms avoid raising
funds using new equity either due to fear of losing control or because of high
transaction cost, therefore, relying more on debt capital. Third, empirical results
indicate that variables other than capital structure also influence firm performance.
For instance, asset tangibility is negatively, whereas firm size and growth are
positively related to performance measures. The positive relationship between firm
size and performance is consistent with the predictions of the trade-off theory suggest
that larger firms tend to borrow more due to their ability to diversify the risk.
Thus, maximum use of debt generates tax savings on interest payments, which in turn
play an important role in improving firm performance. The positive relationship
between firm size and performance is consistent to the findings of Majumdar and
Chhibber (1999). According to Jensen and Meckling (1976) and Myers (1977), managers
of equity-controlled firms tend to invest suboptimally to expropriate wealth from the
firm’s debtholders. The cost associated with this agency relationship is likely to be
higher for firms in growing industries, which have more flexibility in their choice of
future investments. Thus, future growth should be negatively related to the long-term
debt levels (Titman and Wessels, 1988). However, Myers (1977) suggests that this
agency problem can be mitigated if the firm issues short rather than long-term debt.
Notably, profound dependency of Pakistani firms on short-term debt reduces the
tendency of managers to expropriate wealth from the firm’s debtholders, thereby
reducing the associated agency costs, which in turn positively influence the firm
performance. The positive relationship between growth and performance is consistent
to the findings of Lin and Chang (2011).
According to Groth and Anderson (1997), understanding capital structure and its
practical implications is important to the professional manager regardless of functional
area of expertise. For instance, empirical results indicate that using higher than
appropriate levels of debt negatively influence the firm performance. Thus, financial
managers should consider the effects of leverage on performance before making
adjustment in the debt levels. Lenders should carefully inflict debt covenants
considering their impact on corporate performance, because in the event of poor
performance they might have to bear the consequences because of limited liability of
common shareholders. Finally, investors should consider the firm’s debt level before
making investment decisions.
IJCOMA Conclusions
23,4 This study investigates whether capital structure affects the performance of
non-financial firms listed on the KSE Pakistan during 2004-2009. Three panel
econometric techniques, namely pooled ordinary least squares, fixed effects and
random effects, were used to estimate the relationship between capital structure and
firm performance. Empirical results indicate that all measures of capital structure
366 (i.e. total debt ratio, long and short-term debt ratio) are negatively related to return on
assets in all regressions. Moreover, total debt ratio and long-term debt ratio are
negatively related to market-to-book ratio under the pooled OLS model, whereas these
measures are positively related to market-to-book ratio under the fixed effects model.
Short-term debt ratio is positively related to market-to-book ratio in all regressions,
however, the relationship is found insignificant. As far as control variables are
concerned, asset tangibility is negatively, whereas firm size and growth are positively
related to corporate performance.
A negative relationship between capital structure and performance indicates
that capital structure has material effects on firm performance. Moreover, this
finding is incongruent with the irrelevance proposition made by Modigliani
and Miller (1958). Furthermore, the negative relationship between capital structure
and performance indicates that agency issues may lead firms to use higher than
appropriate levels of debt in their capital structure. This overleveraging may
increase the lenders’ influence, which in turn limits the managers’ ability to manage
the operations effectively, hence, negatively affecting the performance. Finally, this
study has some important policy implications for financial managers, lenders, and
investors. For instance, empirical results indicate that financial managers should
consider the effects of leverage on performance before adjusting the debt levels.
Lenders should carefully inflict debt covenants considering their impact on firm
performance. Lastly, investors should consider the firm’s debt level before making
investment decisions.
In sum, this study has laid some groundwork by exploring the impact of capital
structure on performance upon which a more detailed evaluation of Pakistani firms’
capital structure could be based. Moreover, this study proposed to estimate the
relationship between capital structure and firm performance using the data of financial
firms.

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About the authors

Dr Nadeem Ahmed Sheikh is an Assistant Professor at the Institute of Management
Sciences, Bahauddin Zakariya University, Multan. He has earned the degree of doctor of
philosophy in management (business administration) in 2011 from Huazhong University of
Science and Technology, Wuhan, Hubei, P.R. China. He has earned the degree of Master in
business administration (MBA) in 1999 from Bahauddin Zakariya University, Multan. In 1996, he
has earned the degree of bachelor in commerce (BCom.) from Govt. College of Commerce Multan.
Bahauddin Zakariya University has awarded him a Gold Medal in recognition of his 1st position in
BCom. examination. His research interests include capital structure, dividend policy, corporate
governance, capital budgeting, and working capital management. Nadeem Ahmed Sheikh is the
corresponding author and can be contacted at: shnadeem@hotmail.com
Zongjun Wang is a Professor at the School of Management, Huazhong University of Science
and Technology, Wuhan, China. He is the Director of the Department of Management Sciences
and Technology as well as the Director of the Institute of Enterprise Evaluation. Professor Wang
has earned his bachelor degree in computer science in 1985 from Beijing Institute of Technology
(BIT), Beijing. He has earned the degree of doctor of philosophy in system engineering in 1993
from Hauzhong University of Science and Technology, Wuhan. He joined the Montreal
University, Canada in 2001 as a Senior Fellow and Arizona State University as a senior visiting
scholar during 2004-2005. Professor Wang has published more than 150 articles in different
journals (Chinese and international journals) relevant to the field of system engineering,
integrated evaluation methodology and applications, corporate governance, corporate finance,
and management, etc.

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