Proceedings of 32nd International Business Research Conference
23 - 25 November, 2015, Rendezvous Hotel, Melbourne, Australia, ISBN: 978-1-922069-89-4
Impact of Capital Structure on Firm Performance: Evidence from
Manufacturing Sector SMEs in UK
D K Y Abeywardhana*
The purpose of this study is to investigate empirically the impact of capital structure on firm
performance. This study examined the impact of capital structure on firm performance of
manufacturing sector SMEs in UK for the period of 1998-2008. The authors hypothesize that
there is a negative relationship between capital structure and firm performance. To examine
the association, the authors run a Pearson correlation and multiple regression analysis.
Results of this study reveals that there is a significant negative relationship between leverage
and firm performance (ROA, ROCE), strong negative relationship between liquidity and firm
performance and highly significant positive relationship between size and the firm
performance. This study concluded that firms which perform well do not rely on debt capital
and they finance their operations from retained earnings and specially SMEs have less access
to external finance and face difficulties in borrowing funds. It is recommended that firm should
establish the point at which the weighted average cost of capital is minimized and to maintain
the optimal capital structure and thereby maximize the shareholders wealth.
JEL Code: G32
Key words: Capital structure, firm performance, SMEs
1. Introduction
Choice of internal or external financing is one of the serious concerns of a firm. Capital structure and
its impact on firm value and performance is still a puzzle in corporate finance theory and finance
literature. Capital structure theories which are highly based on large firms are failed to explain optimal
mix of debt to equity. Capital structure choice is therefore a crucial issue for both large and small
firms. Well known theory of capital structure irrelevance of Modigliani and Miller (MM) (1958) which
is based on unrealistic assumptions provided the foundation for the development of various theories,
empirical studies on capital structure, as this restrictive assumptions do not hold in the real world.
However finance theory and literature suggest that the optimal capital structure should be employed
but there is no consensus on how to achieve an optimal debt to equity ratio. Further finance theory
does support in understanding the impact of chosen capital structure on value of the firm. Existence
of optimum capital structure minimize the cost of capital and ensure that the profitability of the firm is
maximized. Managing the capital structure properly is paramount important as it would affect the
profitability and finally the value of the firm. In efficient management of capital structure of the firm
would lead to financial distress and ultimately to bankruptcy. Gill et al.(2011) stressed that despite
the fact that there are many theories tried to explain the optimal capital structure researchers in
finance have never yet find a model to determine the optimal capital structure.
Enormous amount of researchers have been examined the capital structure choice on performance
in developed market and for large firms. In developed markets capital markets are more efficient and
suffers less from information asymmetry compared to other emerging economies (Eldomiaty, 2007).
*
Department of Accountancy, University of Kelaniya, Sri Lanka. E mail: dilyapa@kln.ac.lk
Proceedings of 32nd International Business Research Conference
23 - 25 November, 2015, Rendezvous Hotel, Melbourne, Australia, ISBN: 978-1-922069-89-4
Therefore the main focus of this study is to investigate the impact of capital structure on financial
performance of manufacturing sector SMEs in UK which has not adequately research in financial
literature.
2. Literature Review
Impact of capital structure on firm performance has been studied since 1952. Durand, D,(1952) shed
light on introducing theories on capital structure and their impact on value of the firm. Since then it is
received enormous attention in the financial literature among scholars. Due to this inspiration a debate
started among researchers and still it is continuing like a puzzle without consensus. MM(1958) stated
that the capital structure is irrelevant and there is no optimal capital structure based on unrealistic
assumptions. According to Chaganti et al (1995) due to the assumption on rational economic behavior
and perfect market conditions of MM irrelevant theory, it has limited applicability to the small firms.
SMEs differ from the large firms in several aspects and different financing decisions are applied
(Heyman et al., 2008). SMEs have limited access to external finance unlike larger firms and this is
the fact that SMEs are motivated to depend more on the self-generated funds or short term debt.
Studies on capital structure and firm performance are mainly based on the theory of information
asymmetry, signaling and agency cost. Following Jensen and Meckling (1976) several other
researchers (Fama and French, 1998; Gleason et al., 2000; Hadlock and James, 2002) study the
direct effect of leverage on firm performance based on the agency theory and information asymmetry.
Ross (1977) came up with a model that describe the debt to equity ratio choice signals the quality of
the firm. This study explain that low quality firms face high cost to abuse the market and signal about
its high quality through incorporating more debt capital. Firms with low debt capital are inclined to
spend their free cash flow freely and finally generating lower return. In contrast, firm with higher debt
capital work very effectively as they are committed to meet the interest payment of the debt holders
and manage the rest of the cash flow more effectively. Harris and Raviv (1988) explain higher
leverage of the firm as an antitakeover instrument. Higher the leverage of the firm means they bear a
higher risk and the firms with higher risk will be less likely to be acquired. For their own interest
managers of the firm manage higher amount of debt which is not consistent with the agency theory.
Lots of empirical studies focus on impact of debt to equity mix on firm performance as performance
is significantly affected the capital structure of the firm. Titman and Wessels (1988) from the US firms
reported that a negative relationship between capital structure and firm performance. Titman and
Wessels (1988) argue that due to the cost and risk associated with leverage small firms maintain less
relationship with financial institutions which make small firms less preferable clients and they are
charged at high interest rates while large firms are offered competitive interest rates. This is supported
by Rajan and Zingales (1995) and showed that profitability was negatively correlated with leverage.
Confirming this idea Ozkan (2001) further explain that small firms are more sensitive to economic
downturns and face high chance of liquidation in situations of financial distress as they have less
resources available. As a result small firms use more short term debt than larger firms. From a
financial distress perspective as larger firms are more diversified they are expected to go bankrupt
less often than smaller ones (Pettit and Singer (1985), so size must be positively related to leverage.
Proceedings of 32nd International Business Research Conference
23 - 25 November, 2015, Rendezvous Hotel, Melbourne, Australia, ISBN: 978-1-922069-89-4
Investigating the effect of capital structure on profitability of listed firms on the Ghana stock exchange
Arbor (2005) reveal a significantly positive relationship between ratio of short term debt to total assets
and ROE. This suggests that profitable firms use more short term debt to finance their business
operations. Arbor (2007) examined the relationship between capital structure and performance of
SMEs in Ghana and South Africa during a six year period 1998-2003. The empirical results indicate
that short term debt is significantly negatively related to the gross profit margin of both countries and
long term debt has significant positive relationship with gross profit margin of both countries. More
profitable firms should have lower leverage ratio than less profitable firms as they are able to finance
their investment opportunities with the retained earnings according to the theory. Moreover the theory
says that leverage has a negative effect on the firm profitability. This idea is strengthen by Gleason
et al (2000), Arbor (2005) and Arbor (2007) more profitable firms tend to use earnings to pay debt
and therefore they would have a lower leverage than less profitable firms.
Majority of empirical studies in the past confirmed that capital structure has a negative impact on
profitability of the firm. Recently Omondi &Muturi (2013) presented that leverage had a significant
negative effect on financial performance of the firm and Umer (2014) presented again that there is a
negative correlation between capital structure and profitability of the firm. But, Gill, et al.,(2011)
showed that short-term debt; long-term debt; and total debt had positive influence on profitability.
Further Gill,et al., (2011) classified the sample as service and manufacturing sector and found that
the impact of short-term debt and total debt on ROA was positive in both the service and
manufacturing industries.
To sum up, it is proved from the previous discussion, some studies show a positive relationship
between capital structure and firm performance, others show a negative relationship between capital
structure and firm performance. It should be noted that previous empirical findings have demonstrated
that impact of capital structure on firm performance is questionable. The present study was interested
on the effect capital structure on firm performance.
3. Methodology and Model
This section focus on the methodology of this study which will include research design, nature and
sources of data and analysis techniques. Explore most suitable research methodology to achieve the
research objective is the most important role in a research. Therefore methodology of this study had
been adopted to analyze the impact of capital structure on firm performance.
3.1 Variable Selection
The following predictions have summarized based on the trade-off theory, pecking order theory,
agency theory and the previous empirical studies to capture the impact of other variables on
profitability.
3.1.1 Performance
More profitable firms should have lower leverage ratio than less profitable firms as they are able to
finance their investment opportunities with the retained earnings. Leverage has a negative effect on
Proceedings of 32nd International Business Research Conference
23 - 25 November, 2015, Rendezvous Hotel, Melbourne, Australia, ISBN: 978-1-922069-89-4
the firm profitability. This idea is strengthen by Gleason et al (2000), Arbor (2005) and Arbor (2007)
more profitable firms tend to use earnings to pay debt and therefore they would have a lower leverage
than less profitable firms.
In this study two profitability measures are used in which one indicate the firm management use total
assets to make profit and other indicates how well management use the debt and equity capital to
enhance the firm profitability. The profitability is measured using the Return On Assets (ROA)
(Abor,2007;Arcas and Bachiller, 2008;Goddard et al,2005) and return on capital employed
(ROCE)(Krishnan and Moyer,1997).
3.1.2 Capital Structure
In the literature the capital structure is measured in several methods. Three leverage measures use
in this study are total debt to total assets, long term debt to total assets or short term debt to total
assets and gearing ratio. Since long-term debt is issued more rarely, it may measure a longer run
relationship and may be more insensitive to unexpected financial crises than is total debt (Krishnan
and Moyer, 1997). Highly geared firms tend to suffer as the proportion of gross profits dedicated to
servicing debt increases and the proportion accruing to shareholders shrinks accordingly (Goddard
et al, 2005). They found that the relationship between gearing and profitability is negative. According
to the agency cost hypothesis the higher debt or low equity to capital ratio reduces the agency cost.
There are several measures that can be used as a measure as leverage such as debt to total assets
is used as the leverage measure and debt to equity can also be used as a measure of leverage. In
this study leverage is measured by debt to equity ratio.
3.1.3 Control Variables
Apart from the capital structure there are several other variables influence the performance of the
firm. Size of the firm, sales growth and liquidity ratio and capital structure may be influenced by the
firm performance. Firm size is measured by the logarithm of the firm’s assets.
3.2 Modelling
The model of the study is given below based on the variables choose in the previous discussion.
Variable
Name
Performance
Table 1- Variable definition and expected relationship
Variable sign
Sign Definition
ROA, ROCE
Net profit to total assets, Earnings before
interest and tax to capital employed
Proceedings of 32nd International Business Research Conference
23 - 25 November, 2015, Rendezvous Hotel, Melbourne, Australia, ISBN: 978-1-922069-89-4
Capital
structure
Capital
Structure
Capital
Structure
Capital
Structure
Size
TD
+/-
Total debt to total assets
LTD
-
Long term debt to total assets
STD
+/-
Short term debt to total assets
STDTD
+
Short term debt to total debt
LOGSIZE
+
Sales growth
Liquidity
SALESGR
LIQUIDITYR
+
+/-
Natural log of total assets/natural log of
sales
Percentage growth in annual sales
Current assets to current liabilities
3.4 Sampling
Data was obtained from the FAME database. Selecting all firms from Manufacturing sector reduce
the problems associated with selecting a sample from specified industries. This study selects all
private limited firms in manufacturing sector SMEsi in the UK. We use data from 1998-2008. Our
analysis cover data from 1999-2008 as data for year 1998 are used to calculate some variables for
1999. We dropped companies with zero sales. We remove all outliers in the dataset by excluding
observations that lie in the 1% tails of each regression variable. Finally the selected sample consists
of unbalanced panel of 224231 observations.
Descriptive statistics are given in Table 2
Table 2: Descriptive statistics
ROA
ROCE
LOGSALES
LOGSIZE
LIQUIDITYR
SALESGR
TD
STD
LTD
Mean
.0976
.228
8.469
5.991
1.722
.0564
0.561
0.396
0.164
Min
.0003
.0001
2.673
4.56
.0032
-25.67
.001
.016
000
Max
.3241
.6821
12.32
18.97
.962
5.632
.912
.937
.784
SD
.1463
.9640
1.841
3.680
4.302
4.369
1.787
1.478
4.327
N
224231
224231
224231
224231
224231
224231
224231
224231
224231
Source: Author’s computation
Table 2 shows the descriptive statistics for the study. Capital structure proxies STD, LTD and
TD show mean of 39.6, 16.4 and 56.1 respectively for the manufacturing sector SMEs which
implies that SMEs in UK more rely on short term funds and do not incorporate higher level of
long term debt capital in the capital structure. Moreover manufacturing sector SMEs
Proceedings of 32nd International Business Research Conference
23 - 25 November, 2015, Rendezvous Hotel, Melbourne, Australia, ISBN: 978-1-922069-89-4
performance is low for the selected period. This is proved by the mean value of ROA and ROCE
9.76 and 22.8 respectively.
Descriptive statistics shows that 56% of total assets finance through debt, of
which 39.6%
is short term debt showing the fact that Manufacturing sector SMEs in UK are largely depend
on the short term debt for financing their operations may be due to the difficulty in accessing
long term finance or young firms are resistance to use external finance and rely on internally
generated funds.
Table 3: Correlation Matrix
Variable
ROA
ROA
ROCE
SALESGR
LOGSIZE
LIQUIDITYR
TD
STD
LTD
1
ROCE
0.8101
1
SALESGR
0.0003
0.0003
1
LOGSIZE
0.1669
0.2254
-0.0065
1
LIQUIDITYR
-0.0989
-0.0232
-0.0034
-0.0357
1
TD
-0.0386
-0.0438
0.0013
0.1054
-0.1574
1
SDA
0.0696
0.0322
0.0001
0.0192
-0.2037
0.7515
1
LDA
-0.0439
-0.1037
0.0017
0.1326
0.0287
0.5197
-0.1729
1
STDTD
0.0442
0.1082
-0.0032
-0.1209
-0.0632
-0.1833
0.3993
-0.7714
STDTD
1
There does not appear to be high correlation between any of the explanatory variables except the
proxies of performance. Except the proxy for performance and capital structure none of the variable
is highly correlated. Therefore multicollinearity problem does not exist.
3.5 Empirical Model
We measure the effect of capital structure on profitability. The model for the empirical
investigation can be stated as follows.
ROAi,t = α0 + α1 LIQUIDITYRi,t +α2 LOGSIZE i,t + α3 TD i,t + α4SALESGR i,t + α5STDTD i,t + λt +ηi +ε i,t (1)
ROAi,t =α0 +α1 LIQUIDITYRi,t +α2 LOGSIZE i,t +α3 STD i,t +α3 LTD i,t +α4SALESGR i,t +α5STDTD i,t +λt +ηi +ε i,t (2)
Table 4: The impact of capital structure on firm performance ROA
MODEL 1
MODEL 2
Variables
Coefficient
Prob.
Coefficient
Prob.
C
-0.6466
0.0000***
-0.7285
0.0000***
Proceedings of 32nd International Business Research Conference
23 - 25 November, 2015, Rendezvous Hotel, Melbourne, Australia, ISBN: 978-1-922069-89-4
LIQUIDITYR
-0.0123
0.0000***
-0.0171
0.0057**
LOGSIZE
0.0612
0.0000***
0.0638
0.0000***
TD
-0.0642
0.0000***
STD
0.0639
0.0085**
LTD
-0.0651
0.0397**
STDTD
0.0041
0.0221**
0.0033
0.0471**
SALESGR
0.0078
0.1972
0.0072
0.2974
Adjusted R 2
0.845
0.774
*,**,*** indicates statistically significant at 10%, 5% and 1% respectively. As far as the diagnostic tests are concerned
we find no evidence of heteroskedasticity according to White test. Test for second-order serial correlation in the firstdifferenced residuals, asymptotically distributed as N(0,1) under the null of no serial correlation.
An alternative model for above equation can be written as follows with the proxy for the dependent
variable.
ROCE i,t = α0 + α1 LIQUIDITYRi,t + α2 LOGSIZEi,t + α3 TD i,t + α4SALESGR i,t + α5STDTD i,t +λt +ηi +ε i,t (3)
ROCE i,t = α0 + α1LIQUIDITYRi,t +α2LOGSIZEi,t +α3 STD i,t +α3 LTD i,t +α4SALESGR i,t + α5STDTD i,t +λt +ηi +ε i,t (4)
Variable definitions are given in the Table 1.
Table 5: The impact of capital structure on firm performance ROCE
MODEL 3
MODEL 4
Variables
Coefficient
Prob.
Coefficient
Prob.
Proceedings of 32nd International Business Research Conference
23 - 25 November, 2015, Rendezvous Hotel, Melbourne, Australia, ISBN: 978-1-922069-89-4
C
-3.6591
0.5721
-4.2831
0.0056**
LIQUIDITYR
-0.0116
0.0000***
-0.0166
0.0061**
LOGSIZE
2.4857
0.0098**
8.5410
0.0040**
TD
-0.0451
0.0056**
STD
-0.0601
0.0074**
LTD
-0.0561
0.0016**
STDTD
-0.0043
0.0221**
-0.0035
0.0315**
SALESGR
0.0080
0.1918
0.0073
0.4129
Adjusted R 2
0.439
0.642
*,**,*** indicates statistically significant at 10%, 5% and 1% respectively. As far as the diagnostic tests are concerned we
find no evidence of heteroskedasticity according to White test. Test for second-order serial correlation in the firstdifferenced residuals, asymptotically distributed as N(0,1) under the null of no serial correlation
Model estimation using panel data requires first to determine whether there is a correlation between
the unobservable heterogeneity of each firm and other control variables of the model. We would
obtain the consistent estimation by means of the within–group estimator, if there is a correlation (fixed
effects). If not,(random effect) the more efficient estimator can be achieved by estimating the equation
through Generalized Least Squares(GLS). Using the Hausman(1978) test determined whether the
effects are fixed or random under the null hypothesisii.
The estimation is done using two stage least square fixed effect. The analysis is based on variants of
equations incorporating alternative proxies to measure performance iii (ROA, ROCE), leverage [TD
(LTD + STD)]. As can be seen in the variable definition Table 1 there are two alternative measures
for performance, two main alternative measures for leverage of the firm. The result of the panel
estimation is given in Table 4 and 5. Table 4 represent all the sample estimations for ROA and Table
5 represent all the sample estimations for ROCE.
4. Findings
Performance which is measured by ROA and ROCE shows significant positive association with firm
size, so that large size seems to favor the generation of profitability. This is same for the both
measures of size. Increase in profitability with the size of the firm support the earlier findings by Miller
(1977), Fama and French (1998), Abor(2005), and Abor(2007). Capital structure (TD) shows
significant negative relationship with performance and this is contrary to MM (1958) signaling theory
and with Gill, et al., (2011) which explain a higher the debt ratio higher the performance of the firm.
When firm become more levered in the manufacturing sector firms are confronting with the default
risk of incorporation of debt. Liquidity ratio is significantly negative for all measures of performance.
Further this evidence that lack of liquidity has been an important cause of business failure. Sales
growth is insignificant and positively related with the performance Sales growth which could be an
Proceedings of 32nd International Business Research Conference
23 - 25 November, 2015, Rendezvous Hotel, Melbourne, Australia, ISBN: 978-1-922069-89-4
indication of a firm’s business opportunities is an important factor allowing firms to enjoy improved
profitability. This is consistent with the earlier findings of Arbor (2005, 2007). Short term debt to total
debt is highly significant for all the estimations and display a negative relationship with the
performance of the firm implying that short term debt is not profitable for the manufacturing sector
SMEs. Consistent with Fama and French (1998) and Arbor (2007) short term debt is significantly
positively correlated with the performance.
5. Summary and Conclusions
This study has examined the relationship between capital structure and the performance of
manufacturing sector SMEs in the UK for the period of 1998-2008. All the models tested show a good
explanatory poser power on the firm performance.
Positive but insignificant sales growth of sector indicates that the performance of the SMEs in the
manufacturing sector in the UK is not very much influenced by the internal firm characteristics but
might be more influenced by the external factors. Further it can be concluded that in guiding investors
regarding the choice of the firms operational performance, fundamental analysis of the firm sales
growth and efficiency have a little role to play.
It is found that the capital structure of the manufacturing sector SMEs in UK does not follow the MM
(1958) theory of capital structure but this is consistent with the agency theory as higher the leverage
grater the agency cost of outside debt, and many other studies that proved a negative relationship
with leverage and firm performance. This justified that firms which perform well do not rely on debt
capital and they finance their operations from retained earnings and specially SMEs have less access
to external finance and face difficulties in borrowing funds. It is recommended that firm should
establish the point at which the weighted average cost of capital is minimized and to maintain the
optimal capital structure and thereby maximize the shareholders wealth. The size of the firm appears
to be more important factor that determines the performance in SMEs in the UK. In conclusion,
manufacturing sector SMEs in UK are more interesting in internal financing, other than debt finance.
This study with conclude with some important future research areas. It would be suggested to include
ownership structure to the analysis. That would be showing clearly, especially for small firms that
large part of the firm performance could be explained by ownership structure. Further this study
focused only the manufacturing sector and to get a better understanding it can include other sectors
in future research.
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i
European Union definition for SME is used.
If the null hypothesis is rejected the effects are considered to be fixed. The model can be estimated by OLS. Accepting null
hypothesis would mean to have random effects and the model have to be estimated by GLS. More efficient estimator of β we
achieve in this way.
ii
iii
This is extremely important as we can separate the fundamental earning power of the company from the effects of management
financing decision. For instance, firms with identical EBIT may have different net income depends on the different level of debt
finance they employ in the capital structure.