Managerial Finance

How firm characteristics affect capital structure: an empirical study

Nikolaos Eriotis Dimitrios Vasiliou Zoe Ventoura-Neokosmidi
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Nikolaos Eriotis Dimitrios Vasiliou Zoe Ventoura-Neokosmidi, (2007),"How firm characteristics affect capital
structure: an empirical study", Managerial Finance, Vol. 33 Iss 5 pp. 321 - 331
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How firm characteristics affect Firm

characteristics
capital structure: an empirical
study
Nikolaos Eriotis 321
National and Kapodistrian University of Athens, Athens, Greece, and
Dimitrios Vasiliou and Zoe Ventoura-Neokosmidi
Athens University of Economics and Business, Athens, Greece
Abstract
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Purpose – The aim of this study is to isolate the firm characteristics that affect capital structure.
Design/methodology/approach – The investigation has been performed using panel data
procedure for a sample of 129 Greek companies listed on the Athens Stock Exchange during 1997-
2001. The number of the companies in the sample corresponds to the 63 per cent of the listed firms in
1996. The firm characteristics are analyzed as determinants of capital structure according to different
explanatory theories. The hypothesis that is tested in this paper is that the debt ratio at time t
depends on the size of the firm at time t, the growth of the firm at time t, its quick ratio at time t and
its interest coverage ratio at time t. The firms that maintain a debt ratio above 50 per cent using a
dummy variable are also distinguished.
Findings – The findings of this study justify the hypothesis that there is a negative relation between
the debt ratio of the firms and their growth, their quick ratio and their interest coverage ratio. Size
appears to maintain a positive relation and according to the dummy variable there is a differentiation
in the capital structure among the firms with a debt ratio greater than 50 per cent and those with a
debt ratio lower than 50 per cent. These results are consistent with the theoretical background
presented in the second section of the paper.
Originality/value – This paper goes someway to proving that financial theory does provide some
help in understanding how the chosen financing mix affects the firm’s value.
Keywords Corporate finances, Financial flexibility, Capital structure, Greece
Paper type Research paper

1. Introduction
The various financing decisions are vital for the financial welfare of the firm. A false
decision about the capital structure may lead to financial distress and eventually to
bankruptcy. The management of a firm sets its capital structure in a way that firm’s
value is maximized. However, firms do choose different financial leverage levels in
their effort to attain an optimal capital structure. Although theoretical and empirical
research suggests that there is an optimal capital structure, there is no specified
methodology, yet, that financial managers can use in order to achieve an optimal debt
level. However, financial theory does provide some help in understanding how the
chosen financing mix affects the firm’s value.
This paper shed some light on the determinants of the capital structure of the major
Greek firms listed on the Athens Stock Exchange (ASE). We examine the cross-
sectional variation in leverage among the Greek firms for the time period 1997-2001.
We include variables that are based on different capital structure theories and have
never been investigated for the Greek market before, such as the interest coverage ratio
and the quick ratio. We also differentiate the firms that heavily use debt capital (i.e. a Managerial Finance
Vol. 33 No. 5, 2007
debt ratio more than 50 per cent) using a dummy variable. Thus, the conclusions of this pp. 321-331
paper are expected to enlighten the darksome scientific area of the capital structure # Emerald Group Publishing Limited
0307-4358
determination for the Greek firms. DOI 10.1108/03074350710739605
 MF The paper is organized as follows. In the next session, we review some of the
theoretical and empirical literature concerning the determinants and effects of
33,5 leverage. In section 3, we describe our data and we justify the choice of the variables
used in our analysis. The fourth section presents the result of the empirical analysis
and a discussion of the conclusions that can be derived from the results. Finally, we
summarize our findings in the last section.
322 2. Theoretical background
Modigliani and Miller (1958) were the pioneers in theoretically examining and
algebraically demonstrating the effect of capital structure on firm value. Assuming
perfect capital markets[1], they concluded to the broadly known theory of ‘‘capital
structure irrelevance’’ which means that the capital structure that a firm chooses does
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not affect its value. Thereafter, many researchers, including Modigliani and Miller,
examined the effects of less restrictive assumptions on the relationship between capital
structure and the firm’s value. For example, Modigliani and Miller (1963) took taxation
under consideration and they proposed that firms should employ as much debt capital
as possible in order to achieve the optimal capital structure. Along with corporate
taxation, researchers were also interested in analyzing the case of personal taxes
imposed on individuals. Miller (1977) discerns three tax rates in the tax legislation of
the USA that determine the total value of the firm. These are the corporate tax rate,
the tax rate imposed on the income of the dividends and the tax rate imposed on the
income of interest inflows. According to Miller, the value of the firm depends on the
relative height of each tax rate, compared with the other two.
As researchers moved on examining deeper the notion of capital structure, several
theories emerged[2], all of which conclude on the existence of an optimal capital
structure based on balancing the benefits and costs of debt financing. The main benefit
of debt financing is the fact that interest payments are deducted in calculating taxable
income, allowing a ‘‘tax shield’’ for the firms. This ‘‘tax shield’’ allows firms to pay
lower taxes than they should, when using debt capital instead of using only their own
capital. The costs of debt can be viewed mainly from two different aspects. First, there
is an increased probability that a firm may not be able to successfully deal with its
debt obligations (i.e. interest payments); thus, there is an increased probability of
bankruptcy. Second, there are agency costs of the lender’s monitoring and controlling
the firm’s actions. There are additional costs concerning the notion of capital structure
of the firm that arise from the fact that managers possess more information about the
firm’s future prospects than do investors.
The effect of taxation on capital structure has been thoroughly investigated as a
determinant of capital structure. Except for the tax aspects there are also some other
approaches that attempt to explain the determination of the capital structure. These
approaches examine the debt level determination from the perspective of asymmetric
information and agency costs, as already mentioned above. Jensen and Meckling (1976)
identify the existence of the agency problem which arises due to the conflicts either
between managers and shareholders (agency costs of equity) or between shareholders
and debtholders (agency costs of debt).
Managers of firms typically act as agents of the owners. The owners hire the
managers and give them the authority to manage the firm for the owners’ benefit.
However managers are mainly interested in accomplishing their own targets which
may differ from the maximization of the firm value which is the maximization of the
owners’ benefit. They will act in their own interests seeking higher salaries,
 perquisites, job security and in some cases even direct exploitation of the firm’s cash Firm
flows. It is obvious that the interests of the manager not only differ but in many cases
they even oppose to those of the owners. Thus, a conflict of interests between the
characteristics
shareholders and the managers is inevitable. However, the managers have attained the
authority to manage the firm. Thus, the owners may only try to discourage these value
transfers through monitoring and control, such as supervision by independent
directors; these monitoring and control actions presuppose costs, the so-called agency
costs. Perfect control is however extremely costly and therefore, shareholders seek to
323
rely on solutions that would not extract large amounts of value from the firm and
would also monitor and control managers’ operations. A reliable tool can be the use of
debt capital which even adds value to the firm. Leverage will force managers to
generate and pay out cash, simply because interest payments are compulsory. Interest
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payments will reduce the amount of remaining cash flows – the so-called free cash
flows[3] – after the investment decisions, at the disposal of the managers. Thus, debt
can be viewed as a smart device to reduce the agency costs. In this case, the optimal
capital structure will be derived by the balance between the costs of debt against the
benefits of debt; the firm will choose this amount of debt which will minimize its total
agency costs.
Examining the agency costs of debt from the debtholders’ point of view we have to
analyze the lender – borrower relationship. When a lender provides funds to a firm, the
interest rate charged is based on the lender’s assessment of the firm’s risk. This
arrangement creates incentives for the firm to increase its risk without increasing
current borrowing costs. Agency costs of debt only arise when there is a risk of default.
If debt is totally free of default risk, debtholders are not concerned about the income,
value or the risk of the firm. After obtaining a loan at a certain, locked rate from a bank
or through the sale of bonds, the firm can increase its risk. Managers may be tempted
to take actions that transfer value from the firm’s creditors to its shareholders. For
instance, managers could borrow more and pay out cash to shareholders or may invest
in risky projects. To avoid this situation lenders impose certain monitoring and
controlling techniques on borrowers. Debtholders typically protect themselves by
including provisions that prohibit the management of the firm to significantly alter its
business or financial risk. These provisions mainly refer to the level of net working
capital, asset acquisitions, executive salaries and dividend payments. These protective
covenants allow the lender to monitor and control the firm’s risk. Alternatively, if no
protective covenants are accepted by the firm, creditors may demand higher returns, in
the form of higher interest rates. However all these actions enclose some direct or
indirect costs that the firm is subject to; these are the agency costs of debt, from the
debtholders’ point of view. In exchange for incurring agency costs by agreeing to cope
with the restrictions placed by the lenders, the firm and its owners benefit by obtaining
funds at a lower cost. The optimal capital structure of the firm will be formed at this
particular level where the benefits of the debt that can be received by the shareholders
balance with the costs of debt imposed by the debtholders.
The notion of asymmetric information in determining the optimal capital structure
is primarily expressed by Myers (1984) and Myers and Majluf (1984). Myers and Majluf
(1984) assumed that managers make decisions with the goal to maximize the wealth of
existing shareholders. Therefore, they avoid issuing undervalued stock unless the
value transfer from ‘‘old’’ to new shareholders is more than offset by the net present
value of the growth opportunity. This leads to the conclusion that new shares will only
be issued at a lower price than that imposed by the real market value of the firm.
 MF Therefore, an announcement of new equity issue is directly interpreted as a negative
signal, in the sense that current investors possess overvalued shares. This negative
33,5 signal results in the stock price decline. Indeed, several studies[4] have confirmed that
the announcement of a stock issue have resulted in a decline of the stock price. That is
why several firms tend to follow the ‘‘pecking order’’ financing pattern. The ‘‘pecking
order’’ theory suggests that firms will initially use internally generated funds, i.e.
undistributed earnings, where there is no existence of information asymmetry, then
324 they will draw debt capital if additional funds are needed and finally they will turn to
new equity issue to cover any remaining capital requirements. Thus, highly profitable
firms that generate high earnings are expected to use less debt capital than those that
are not very profitable. Several researchers have tested the effects of profitability on
firm leverage. Kester (1986) and Friend and Lang (1988) conclude that there is a
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significantly negative relation between profitability and debt/asset ratios. Rajan

and Zingales (1995) and Wald (1999) find a significantly negative relation between
profitability and debt/asset ratios for the USA, the UK and Japan.
At this point we should mention that the notion of information asymmetry implies
that firms should maintain some reserve borrowing capacity which will allow them
to take advantage of good investment opportunities by issuing debt capital if
necessary. The notion of asymmetric information is also used to combine the growth
opportunities of a firm with its capital structure. Growth causes variations in the value
of a firm. Larger variations in the value of the firm are often interpreted as greater risk.
That is why a firm that has considerable growth opportunities will be considered as a
risky firm and will face difficulties in raising debt capital with favorable terms. Thus, it
will employ less debt in its capital structure. On the other hand, the cash flows of a firm
which value is most likely to remain stable in the future are predictable and its capital
requirements can be financed with debt more easily than these of a firm with growth
potential. Myers (1977) argues that firms with growth potential will tend to have lower
leverage.
To sum up, there is no universal theory of the debt-equity choice. There are several
useful conditional theories that attempt to approach the determination of capital
structure, each from different aspect. In this paper, we examine some specific factors
that determine the capital structure of the Greek firms.

3. Data and measurement of variables

In this paper, we investigate the determinants of capital structure for the firms listed in
the ASE market during the period 1997-2001. All the companies included in the sample
fulfil the following two criteria; they were all listed in the market in 1996 and none of
them was expelled during the period 1997-2001. These criteria were imposed to ensure
that the capital structure was not distorted by the effects of a recent official listing. We
form our variables using data derived from the financial statements contained in the
ASE database. The final sample, after considering any missing data, consists of 129
firms. This figure represents the 63 per cent of the listed companies on the ASE in 1996.
Thus, our sample consists of a significant proportion of the listed firms in the ASE
during the five-year-period 1997-2001.
Our dependent variable is the debt ratio (variable: DRi,t) which is defined as the ratio
of total debt divided by the total assets of the firm. Total debt contains both long-term
and short-term liabilities. Although the strict notion of capital structure refers
exclusively to long-term leverage, we have decided to include short-term debt as
well, mainly because Greek firms use either very little – less than 10 per cent – or no
 long-term capital. Banks in Greece are hesitant in providing long-term financing with Firm
attractive terms. Therefore, Greek firms turn to short-term borrowing even when
financing their long-term investments. That is why we also consider short-term
characteristics
financing as a measure of gearing.
The next variable we consider refers to the size of the firm. Size can be considered as
a potential explanatory determinant of differences in leverage among the firms
contained in the samples. Size is closely related to risk and bankruptcy costs. Larger
firms are usually more diversified and thus bear less risk. Therefore, they have a lower
325
probability of default. Furthermore, larger firms will more easily attract a debt analyst
to provide information to the public about the debt issue. Banks are more willing to
lend their funds to larger firms partly because they are more diversified and partly
because larger firms usually request larger amounts of debt capital than smaller firms.
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As a consequence, larger firms are usually able to reduce transaction costs associated
with long-term debt issuance and can arrange a lower interest rate. Examining the
effect of size in the determination of capital structure, Marsh (1982) and Bennett and
Donnelly (1993) found that larger firms are likely to use more debt. Thus, we expect
that there will be a positive relation of size to leverage. We proxy the size of the firm
considering its sales (variable: SIZEi,t). The higher sales revenue a firm has, the bigger
it is considered to be.
As mentioned before, we also include short-term debt in our dependent variable.
Thus, it is expected that the rate with which the firm covers its short-term debt has a
strong influence in the debt ratio. Furthermore, the short-term leverage coverage is an
indication of the liquidity of the firm. That is why we also consider the relation
between the liquidity of the firm and its capital structure. We use the quick, or acid test,
ratio (variable: LIQi,t) which is equal to current assets minus inventories divided by
current liabilities. This ratio shows the ability of the firm to cover its short-term
liabilities and it measures the liquidity of the firm. We expect that there will be a
negative relation between the debt ratio of the firm and its liquidity simply because the
more debt the firm uses the more current liabilities this will imply and the fewer
current assets will remain after dealing with the liabilities. Nevertheless, the fact that a
firm employs more current assets implies that it can generate more internal inflows
which can then use to finance its operating and investment activities. Thus if the
negative relation will be confirmed, there is an implication that firms finance their
activities following the financing pattern implied by the ‘‘pecking order’’ theory.
Another variable that we consider is the interest coverage ratio which is expressed
as net income before taxes divided by interest payments (variable: INCOVi,t). The
interest coverage ratio has already been theoretically investigated as a determinant of
capital structure. Harris and Raviv (1990) propose that leverage is negatively
correlated with the interest coverage ratio. They argue that an increase in debt results
in a higher default probability. Assuming that interest coverage ratio is a measurement
of default probability, this implies that a higher interest coverage ratio indicates a lower
debt ratio.
Next, we also investigate if there is a relation between the growth of the firm and its
capital structure (variable: GROWTHi,t). We proxy our growth measurement as the
annual change on earnings. As already mentioned in the previous section, there should
be a negative relation between this regressor and our dependent variable.
Since the capital structure of the firm is actually the relation between the total debt
and the assets of the firm, we expect that firms that employ more debt than equity will
maintain a different capital structure than the market as a whole. In order to capture
 MF and isolate that difference made by those firms we introduce a dummy variable, which
distinguish them from the whole (variable: DUMMYDRi,t). More specifically, the
33,5 dummy is set equal to one for firms which debt ratio is more than 50 per cent, and zero
otherwise. The impact of this dummy variable is that the estimated model describes
the behavior of the market as a whole and provides information concerning the extra
volume of debt that those firms use compare to the market.
326 4. The model
In order to combine cross-sectional with time series data and formulate the
characteristics of the market, we use pooling methods for our panel data. The models
for panel data are powerful research instruments, which give the researcher the ability
to take in to account any kind of effect that the cross-sectional data may have, and
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finally to estimate the appropriate empirical model. A general model for panel data that
allows the researcher to empirically estimate the relation between dependent and
independent variables with great flexibility and formulate the differences in the
behavior of the cross-section elements is theoretically as follows[5]:
yit ¼ xit0
þ z0it a þ "it

where yit is the dependent variable, xi the matrix with the independent variables and zi
a matrix which contains a constant term and/or a set of individual or group specific
variables (depending on the sample), which may be observed or unobserved.
In case where, in the original model the matrix z includes only a constant term the
model can be estimated as a classical linear model and provide the researcher with
unbiased coefficient matrix. The method to perform the analysis is the pooled least
square. On the other hand, if the observations have individual or group effects then
those effects must be taken in to account and have to be included into the z matrix.
There are two ways to estimate the model that includes those effects. The first one, the
random effects model estimates the coefficient matrix under the assumption that the
individual and/or group effects are uncorrelated with the other independent variables
and can be formulated and the second one, the fixed effects model, which relaxes these
two restrictions. Since, there is not justification that the effects should be treated as
uncorrelated with the other regressors, the random effects model may suffer from
inconsistency due to omitted variables[6]. In order to have an indication about
the correlation between the effects and the independent variables, Hausman (1978)
perform a test concerning the relation between the effects and the regressors.
The hypothesis that will be tested is that total debt (short- and long-term debt) can
be seen as a function of the size of the firm, its ability to successfully fulfil its short run
debt, the interest rate coverage ratio, the growth of the firm and the proportion of the
extra debt that the firm, with equity less than the 50 per cent of the total assets, uses.
Modeling the Greek market according to the variables described in the previous
section, we estimate the following model:
DRi;t ¼
0 þ
1 SIZEi;t þ
2 LIQi;t þ
3 INCOVi;t
þ
4 GROWTHi;t þ
5 DUMMYDRi;t þ "i;t ð1Þ

where DRi,t is the debt ratio of the firm i at time t, SIZEi,t the size of the firm i at time t,
LIQi,t the quick ratio of the firm i at time t, expressed as current assets minus
inventories divided by current liabilities, INCOVi,t the interest coverage ratio of firm i at
time t, expressed as net income before taxes divided by interest payments, GROWTHi,t
 the percentage change in earnings of the firm i between time t and t
1, DUMMYDRi,t Firm
the dummy variable for DRi,t greater than 50 per cent and i,t the error term. characteristics
5. Empirical results
In order to estimate the effect of the independent variables on the dependent and to
improve our results we consider the three different econometric approaches presented
in the previous section. Under the hypothesis that there are no group or individual 327
effects among the firms included in our sample we estimate the total model. The results
are presented in Table I. The diagnostics provide us with useful results concerning the
theoretical model presented in equation 1. All the variables proved to be significant in
confidence level of 5 per cent. The power of the model is given by the high F-statistic of
1,352.4. According to adjusted R2 the independent variables explain the 92 per cent of
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the size in the debt ratio.

In the analysis of panel data, where cross-section combined with time series data,
there might be cross-section effects on each firm or on a set of groups of firms. There
are two procedures to deal with those effects and each of them has already presented in
the beginning of section 4. These two approaches are the random and the fixed effects
models for panel data. The case where all the effects are uncorrelated with the
regressors and can be formulated as constant terms for each individual or group of
firms in the known matrix z, is presented in Table II. The diagnostics from the random
effects model suggest that the variable of growth is not statistically significant and
does not affect the debt ratio. The adjusted R2 is lower than that of the total model at
83.5 per cent.
In random effects model there are three assumptions about the cross-section effects.
The first is that there exist group or individual effects, the second that those effects are
uncorrelated with the independent variables and the third that the effects can be
formulated. The case where the major assumption about the effects does not hold
(i.e. there are no effects) has already presented in Table I. The next step is to stay
consistent with the major assumption, there are effects, and relax the last two
restrictions concerning them. The results from the fixed effect model are presented in
Table III. According to Table III all the independent variables of our model are

Variable Coefficient Std. error t-statistic Prob.

C 0.302464 0.008713 34.71596 0.0000

SIZE 6.21  10
11 1.71  10
12 36.35105 0.0000
LIQ
0.011476 0.004888
2.347688 0.0192
INCOV
1.37  10
6 2.40  10
7
5.702233 0.0000
GROWTH
4.59  10
6 1.92  10
7
23.87668 0.0000
DUMMYDR 0.341478 0.007514 45.44843 0.0000
Weighted statistics
R2 0.919998 Mean dependent var. 0.502023
Adjusted R2 0.919318 SD dependent var. 0.426139
SE. of regression 0.121043 Sum squared resid. 8.615047
F-statistic 1,352.366 Durbin–Watson stat. 1.294846 Table I.
Prob (F-statistic) 0.000000 The effect of the
independent variables on
Notes: Dependent variable: DR; Method: GLS (cross-section weights); White heteroskedasticity- the dependent using the
consistent standard errors and covariance total model
 MF Variable Coefficient Std. error t-statistic Prob.
33,5
C 0.307623 0.008897 34.57707 0.0000
SIZE 7.57  10
11 1.63  10
11 4.644296 0.0000
LIQ
0.004909 0.000834
5.888968 0.0000

6
7
INCOV
1.12  10 4.41  10
2.530628 0.0116
GROWTH
2.49  10
6 3.06  10
6
0.812516 0.4168
328 DUMMYDR 0.268865 0.011178 24.05228 0.0000
GLS transformed regression
R2 0.836422 Mean dependent var. 0.382953
Table II. Adjusted R2 0.835031 SD dependent var. 0.217482
The effect of the SE of regression 0.088333 Sum squared resid. 4.588026
independent variables on Durbin–Watson stat. 1.391236
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the dependent using the

random effects model Notes: Dependent variable: DR; method: GLS (variance components)

statistically significant at 5 per cent. The F-statistic proves the high explanatory power
of the estimated model and the high R2 (adjusted) indicates that the estimated model
explain the 97.2 per cent of the size in the dependent variable.
According to our findings there is a contradictory result concerning the variable of
growth. The total and the fixed effects model accept this variable but the random effects
model does not. These controversial results indicate that further analysis has to be done.
As we mention in section 4 the random effects model assumes that the individual effects
are uncorrelated with the independent variables. In consequence, the random effects
model may suffer from inconsistency as a result of omitted variables, something that
does not happen with the fixed effects model. On the other hand, the fixed effects model
uses the individual effects as given by the sample. In order to see if the individual effects
are uncorrelated with the regressors we perform a Hausman test. The test statistic is
565.3 and the critical value of the chi–square table with five degrees of freedom, at 95
per cent, is 11.7, which is lower than the test’s value. Hence, the hypothesis that the
individual effects are uncorrelated with the regressors can be rejected. The random
effects model estimates suffer from inconsistency probably due to omitted variables (see

Variable Coefficient Std. error t-statistic Prob.

SIZE 4.35  10
11 1.03  10
11 4.235927 0.0000

LIQ
0.003551 0.000756
4.699572 0.0000
INCOV
1.11  10
6 1.15  10
7
9.631313 0.0000
GROWTH
1.45  10
6 5.78  10
7
2.509531 0.0124
DUMMYDR 0.199252 0.003510 56.75966 0.0000
Weighted statistics
R2 0.977800 Mean dependent var. 0.543577
Adjusted R2 0.971871 SD dependent var. 0.470460
Table III. SE of regression 0.078904 Sum squared resid. 2.913721
The effect of the F-statistic 5,153.334 Durbin–Watson stat. 2.076985
independent variables on Prob (F-statistic) 0.000000
the dependent using the
fixed effects model Notes: Dependent variable: DR; method: GLS (cross-section weights)
 section 4). Hence, according to our sample and findings, the appropriate model to Firm
explain the market is the one that includes the GROWTH variable. characteristics
According to our findings the SIZE of the firm has a positive relation with the debt
ratio, something that has been confirmed by Marsh (1982) and Bennett and Donnelly
(1993), which found similar results with us. This suggests that larger firms use more
debt. The short-term leverage coverage is an indication of the liquidity of the firm. As
we expected there is a negative relation between the debt ratio of the firm and its 329
liquidity. The negative relation confirms that firms finance their activities following
the financing pattern implied by the ‘‘pecking order’’ theory. As we expected the
negative relation between debt and growth has been confirmed from our data. The
statistical significance of the dummy variable and its positive sign indicate that there is
a distinction in the capital structure between firms who have debt ratio greater than 50
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per cent and those that do not have. According to our results from the fixed effects
model these firms use, compared to the market, an extra debt of 19 per cent.

6. Conclusions
In this study, we conduct our analysis in order to investigate how some specific firm
characteristics determine the firm’s capital structure. We use the panel data derived by
the financial statements of 129 Greek firms listed in the ASE. In our calculations we
consider the total model, the fixed effects model and the random effects model.
Our dependent variable is the debt ratio expressed as total liabilities divided by total
assets. The debt ratio includes both long-term and short-term liabilities mainly because
Greek firms use either very little or no long-term debt capital at all. According to the
results, the debt ratio of the firm is positively related to its size which is measured by
the sales figure. Thus, larger firms employ more debt capital in comparison with
smaller firms, a finding which is consistent with the theoretical background mentioned
in the second section of the paper.
On the other hand, our findings show that the liquidity of the firm is negatively
related to its financial leverage. We consider the liquidity of the firms using the quick,
or acid test ratio which is equal to current assets minus inventories divided by current
liabilities. This ratio shows the ability of the firm to deal with its short-term liabilities.
Firms with high liquidity tend to use less debt. This finding can be considered as an
indication that firms generally finance their activities following the financing
procedure implied by the pecking order theory. Firms with high liquidity maintain a
relatively high amount of current assets, which means that they maintain high cash
inflows. This means that they also generate high cash inflows. As a consequence, they
are able to use these inflows in order to finance their operating and financing activities.
Thus, they do not use much debt capital in comparison with firms that are not so
profitable because they prefer to use these funds rather than debt capital; this is an
indication of pecking order financing.
This finding is further supported by the result of the negative relation between the
interest coverage ratio of the firms and their capital structure. The interest coverage
ratio is expressed as net income before taxes divided by interest payments. Thus, firms
that maintain a relatively high interest coverage ratio prefer to use less debt capital. If a
firm has a high interest coverage ratio, this means that it has the ability to generate
relatively high earnings. The negative relation implies that firms probably prefer to
use these earnings to finance their activities and thus use less debt capital; this is also
an implication of the pecking order financing.
 MF The negative relation between the growth of the firm and its capital structure shows
33,5 that firms with high growth potential employ less debt in their capital structure. We
proxy our growth measurement as the annual change on earnings. Thus, high growth
means high variation in earnings which can be interpreted as higher risk. Firms that
are risky generally find it difficult to raise debt capital, simply because the lenders will
demand higher returns making debt capital more expensive.
According to the results of the dummy variable, we find strong evidence that there
330 is a capital structure differentiation among the firms which heavily use debt capital
(more than 50 per cent of their total assets) and those that use less debt capital.
The results and conclusions are consistent with the theoretical background as
presented in the second section of the present paper. All the three models conclude in
the same remarks except for the situation of the growth variable. The growth variable
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is not statistically significant in the random effects model, but it is in the other two
models. However, the Hausman test indicates that the fixed effects model fits better to
our specific set of variables and thus prevails over the random effects model. Thus,
growth does affect the determination of capital structure.

Notes
1. Perfect capital markets means that the following assumptions hold: (a) there are no
taxes, (b) there are no transaction costs, (c) there is symmetrical information, (d) there
are homogenous expectations and (e) investors can borrow at the same rate as
corporations.
2. Harris and Raviv (1991) refer to various theories of capital structure.
3. For more information about the free cash flows hypothesis see Jensen (1986).
4. See for example Asquith and Mullins (1986).
5. For more information, see Greene (2003).
6. For further analysis see Hausman and Taylor (1981) and Chamberlain (1978).

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Corresponding author
Nickolaos Eriotis can be contacted at: neriot@econ.uoa.gr; nikolaos.eriotis@aueb.gr

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