Debt Ratio RRL

Various studies have been conducted that show debt ratio as a measure of corporate

profitability. Muscettola (2014) notes that several studies show a positive relationship between

debt and profitability. Others show otherwise, while some show a lack or an absence of a

relationship between the two variables. Kester (1986) was one of those who noted a negative

relationship between profitability and debt ratios in American and Japanese manufacturing firms.

Graham (2004) reveals similar results, indicating a negative connection between debt and

corporate profitability, especially for firms that are large and significantly more profitable, as

well as a study done by Abor (2005) which revealed that there is an inverse relationship between

profitability of Ghanian listed firms and their debt ratios. These results mirror that of Myers

(1984) which states that instead of finding a firm’s optimal debt ratio, the firm will follow a

certain financing pecking order which states that primarily, when in need of financing, firms

prefer internally generated funds. If external financing is a requirement, such firms will issue

debt first, followed by a mix of securities, and equity as the last option. Previous studies have

shown, however, that leverage can reveal different relationships with profitability depending on

the debt ratio utilized. For example, a study by Abor (2005) revealed that shot-term debt and

total debt had a positive relationship with profitability, while long-term debt had a negative

relationship. Titman & Wassels (1988) shows in their study that firms who don’t utilize debt but

instead use their earnings are more profitable, because of less leverage as compared to firms

which rely more on external financing. Sheel (1994) studied the hotel industry and the

manufacturing sector and also supported the negative relationship between a firm’s debt ratio

and profitability. In addition, Mandelker & Rhee (1984) stated that profitable firms in various

industries often have the lowest debt ratios and also found that large returns for a firm’s
shareholders are attributed to events that increase leverage such as a stock repurchase or debt for

equity exchange, instead of leverage decreasing events, such as stock issuances.

Muscettola, M. (2014b). Structure of assets and capital structure. What are the relations with each
other? An empirical analysis of a sample of Italy. European Journal of Business and Social Sciences 2(11):
55-69.

Kester WC (1986) Capital & ownership structure: a comparison of United States &
Japanese manufacturing companies. Asian Economic Journal 20(3): 275-302.

Graham, JR. (2004). How big are the tax benefits of debt. Journal of Finance 55: 1901-
41

Abor J (2005) The effect of capital structure on profitability: An empirical analysis of

listed firms in Ghana. The Journal of Risk Finance 6(5)

Myers, S. C. & Majluf, N. S. (1984). Corporate financing and investment decisions when
firms have information that investors do not have. Journal of Financial Economics, 13
(2), 187-221.

Titman S. & Wessles, R. (1988). The determinants of capital structure choice. Journal of Finance, 43, 1-
19.

Sheel, A. (1994). Determinants of capital structure choice and empirics on leverage behavior: A
comparative analysis of hotel and manufacturing firms. Hospitality Research Journal, 17, 3-16

Mandelker, G. & Rhee, S. (1984). The impact of the degree of operating and financial leverage on
systematic risk of common stock. Journal of financial and Quantitative Analysis ,30, 45-57.