International Journal of Science, Technology & Management
Volume No.04, Issue No. 02, February 2015
www.ijstm.com
ISSN (online): 2394-1537
CAPITAL STRUCTURE AND ITS IMPACT ON
PROFITABILITY
Dr. N. Srinivas Kumar
Professor, SRTIST, Nalgonda, (India)
ABSTRACT
The purpose of this study were to determine relationship between two capital structure mechanisms (debt to
equity and debt to total funds) and three profitability measures (ROCE, ROE and NIM) of a sample of SME
financial year 2008-2013. The data have been analyzed by using descriptive statistics and correlation analysis
to find out the association between the variables. The results show that there is a significant impact of capital
structure on ROCE while insignificant with ROE.
Keywords: ROE, ROCE, Debt, Total funds.
I. INTRODUCTION
Capital structure is one of the most puzzling issues in corporate finance literature (Brounen & Eichholtz, 2001).
The relationship between capital structure and profitability is one that receives considerable attention in the
finance literature. Each and every business organizations need adequate fund to run its business effectively and
efficiently. A firm can raise fund from different sources and take different forms. However, the capital can
mainly be categorized into two debt and equity. How a firm financed? Either with all debt or all equity or mix of
both. What is the optimum mix that leads to the maximum value of a firm? Capital structure theory deals with it.
Thus the proportion of debt to equity is a strategic choice of corporate managers. In finance, the most debatable
topic is capital structure. The main issue of debate revolves around the optimal capital structure. So capital
structure refers to the way a firm finances its assets through some combination of equity, debt, or hybrid
securities. A firm's capital structure is then the composition or 'structure' of its liabilities. Profitability is the
ability of a firm to generate net income on a consistent basis. Ratios are used as a benchmark for evaluating the
performance of a firm. Ratios help to summarize large quantities of financial data and to make qualitative
judgment about the firm’s profitability. So Capital structure decision is the vital one since the profitability of an
enterprise is directly affected by such decision. Hence, proper care and attention need to be given while
determining capital structure decision.
The relationship between capital structure and profitability is one that received considerable attention in the
finance literature. The modern industrial firm must conduct its business in a highly complex and competitive
business environment. Therefore, these types of research findings will be benefited in selecting the capital
structure to achieve the optimum level of firm’s profitability.
This study shows the statistical analysis carried out seeking to discover is there any relationship between capital
structure and profitability of SME.
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International Journal of Science, Technology & Management
Volume No.04, Issue No. 02, February 2015
www.ijstm.com
ISSN (online): 2394-1537
The present era is the era of intense competition and survival of the fittest is the slogan of the corporate world.
In such a scenario decision making has emerged as one of the toughest tasks as it decides the fate of every firm.
Therefore, managers have to take into consideration the cause effect relationship while making a particular
decision. The managers of present corporate world have to follow systems approach in their decision making
because a decision taken in isolation can bring a firm to the verge of a disaster.
Of all the aspects of capital investment decision, capital structure decision is the vital one, Since the profitability
of an enterprise is directly affected by such decision. Hence, proper care and attention need to be given while
making the capital structure decision. There could be hundreds of options but to decide which option is best in
firm's interest in a particular scenario needs to have deep insight in the field of finance as use of more proportion
of Debt in capital structure can be effective as it is less costly than equity but it also has some limitations
because after a certain limit it affects company's leverage. Therefore, a balance needs to be maintained.
II. OBJECTIVES OF THE STUDY
The objectives of this research are geared towards the following:
· To identify the relationship between capital structure and profitability of SME
· To find an optimal capital structure that would be associated with the best performance.
· To find out the impact of capital structure on profitability.
III. SCOPE OF THE STUDY
A study of capital structure and its impact on profitability involves examination of debt and equity as well as
total funds, return on equity and return on capital employed. The scope of the study is confined to the sources
that of SME taapped over the years under study ie 2008-2013. The time period considered for evaluating the
study is five years.
IV. LIMITATIONS OF THE STUDY

The present study is confined to SME

The study is analysed with the help of correlation .

The analysis was restricted to the data available in the balance sheet of SME.
4.1 Data Analysis
4.1.1 Research Model
A correlation analysis is used to investigate one variable from one or more other variables. Here also this
analysis was performed to identify the impact of capital structure on profitability. To test the relationship
between capital structure and profitability, the following function was considered.
P=ƒ (ROCE, ROE and NIM)
Which shows profitability is the function of capital structure. Here capital structure is measured with the help of
Debt to equity ratio and Debt to total funds ratio. It is important to note that the profitability is measured with
the help of three ratios namely Return on Capital employed and Return on equity
25 | P a g e
International Journal of Science, Technology & Management
Volume No.04, Issue No. 02, February 2015
www.ijstm.com
ISSN (online): 2394-1537
4.2 Return on Capital Employed
A financial ratio that measures a company's profitability and the efficiency with which its capital is employed.
Return
on
ROCE
=
Capital
Earnings
Employed
Before
Interest
(ROCE)
and
is
Tax
(EBIT)
calculated
/
Capital
as:
Employed
“Capital Employed” as shown in the denominator is the sum of shareholders' equity and debt liabilities; it can be
simplified as (Total Assets – Current Liabilities). Instead of using capital employed at an arbitrary point in time,
analysts and investors often calculate ROCE based on “Average Capital Employed,” which takes the average of
opening and closing capital employed for the time period.A higher ROCE indicates more efficient use of capital.
ROCE should be higher than the company’s capital cost; otherwise it indicates that the company is not
employing its capital effectively and is not generating shareholder value.
Table: 1 Calculation of ROCE (Return On Capital Employed
CAPITAL
YEARS
PBIT
EMPLOYED
ROCE
2008-2009
17609584
56423390
31.20972349
2009-2010
36095913
170830411
21.12967638
2010-2011
71508287
145956088
48.99301426
2011-2012
127671891
287662207
44.38257369
2012-2013
111747738
3555380362
3.14
4.2.1 Interpretation

The above table depicts the PBIT was constantly increasing from 2008-2013.

The significant increase in the profit shows the profitability of the SME.

The earnings of the SME were in increasing ratio.

The opening Capital employed and closing capital employed were also indicating efficient use of the
capital. The higher the return on the capital employed the higher the shareholders value.
4.3 Return on Equity
The amount of net income returned as a percentage of shareholders equity. Return on equity measures a
corporation's profitability by revealing how much profit a company generates with the money shareholders have
invested.
ROE
Return
is
expressed
on
Equity
as
a
=
percentage
Net
and
calculated
Income/Shareholder's
as:
Equity
Net income is for the full fiscal year (before dividends paid to common stock holders but after dividends to
preferred
stock.)
Shareholder's
equity
does
not
include
preferred
shares.
Also known as "return on net worth" (RONW).
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International Journal of Science, Technology & Management
Volume No.04, Issue No. 02, February 2015
www.ijstm.com
ISSN (online): 2394-1537
Table: 2 Calculations of ROE (Return on Equity)
YEARS
NET PROFIT BIT
EQUITY
ROE
2008-2009
17609584
12422000
141.7612623
2009-2010
36095913
18633000
193.720351
2010-2011
71508287
18633000
383.7722696
2011-2012
127671891
32192000
396.5950888
2012-2013
111747738
41737000
267.7426217
4.3.1 Interpretation

The net profit in the year 2008 is 17609584 lacs were as in the year 2012-13 the net profit margin is
Rs.111747738, lacs which is healthy and positive sign for the SME.

The shareholders value was constantly increasing from the past five years.

The return on equity signifies the efficient use of the capital employed.
4.4 Debt to Equity
A measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It
indicates what proportion of equity and debt the company is using to finance its assets.
=Total Liabilities
------------------------Shareholders Equity
Note: Sometimes only interest-bearing, long-term debt is used instead of total liabilities in the calculation.
Also known as the Personal Debt/Equity Ratio, this ratio can be applied to personal financial statements as well
as corporate ones.
A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt.
This can result in volatile earnings as a result of the additional interest expense.
Table: 3 Calculation of Debt to Equity
YEARS
DEBT
EQUITY
DEBT TO EQUITY
2008-2009
41178045
12422000
331.4928755
2009-2010
91727027
18633000
492.2826544
2010-2011
363928735
18633000
1953.140852
2011-2012
927662724
32192000
2881.656076
2012-2013
1225470915
41737000
2936.173934
4.4.1 Interpretation

The debt to equity ratio shows that the company is aggressive in financing its growth with debt

The increasing trend of debt to equity ratio signifies that if a lot of debt is used to finance increased
operations (high debt to equity), the company could potentially generate more earnings than it would have
without this outside financing.

This results in volatile earnings as a result of the additional interest expense.
27 | P a g e
International Journal of Science, Technology & Management
Volume No.04, Issue No. 02, February 2015
www.ijstm.com
ISSN (online): 2394-1537
4.5 Debt to Total Funds
A measurement of a company's financial leverage, calculated as the company's debt divided by its total capital.
Debt includes all short-term and long-term obligations. Total capital includes the company's debt and
shareholders' equity, which includes common stock, preferred stock, minority interest and net debt Calculated
as:
Table: 4 Calculation of Debt to Total Funds
YEARS
DEBT
EQUITY
DEBT TO
FUNDS
2008-2009
41178045
12422000
76.82464632
2009-2010
91727027
18633000
83.11616941
2010-2011
363928735
18633000
95.12941356
2011-2012
927662724
32192000
96.64615913
2012-2013
1225470915
41737000
96.70638105
TOTAL
4.5.1 Interpretation

The debt to total funds ratio tells about the companys strength. The increasing figures of debt to total funds
from the year 2008-2013 clearly shows that the SME is in good position and earning profitability.

The higher the debt-to-capital ratio, the more debt the company has compared to its equity.

The year 2008-2009 shows 76.82 and the year 2012-2013 shows 96.70 therefore we can conclude that the
financial position of the company is sound.
V. RESULTS AND ANALYSIS DESCRIPTIVE STATISTICS OF VARIABLES
5.1 Interpretation
The descriptive statistics above show that over the period under study, the profitability ratios measured by return
on capital employed, return on equity and averaged 29,277 respectively. The debt/equity ratio stood at 1719 and
debt to total funds averaged 89.80. This is an indication that approximately 89% of total assets in the SME is
represented by debt, confirming the fact that the maximum and minimum values for debt/equity ratio indicate
that the debt/equity composition varies substantially among the SME.
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International Journal of Science, Technology & Management
Volume No.04, Issue No. 02, February 2015
www.ijstm.com
ISSN (online): 2394-1537
VI. CORRELATION ANALYSIS
TABLE NO. 02:
CORRELATIONS MATRIX FOR CAPITAL STRUCTURE AND PROFITABILITY
Correlations
DEBT
TO
EQUITY
DEBT
TO
ROCE
ROE
.958*
-.027
.780
.010
.966
.120
5
5
5
1
.079
.875
.900
.052
TOTAL
FUNDS
DEBT TO EQUITY
Pearson Correlation
1
Sig. (2-tailed)
N
DEBT
TO
TOTAL
FUNDS
ROCE
ROE
5
*
Pearson Correlation
.958
Sig. (2-tailed)
.010
N
5
5
5
5
Pearson Correlation
-.027
.079
1
.547
Sig. (2-tailed)
.966
.900
N
5
5
5
5
Pearson Correlation
.780
.875
.547
1
Sig. (2-tailed)
.120
.052
.340
N
5
5
5
.340
5
*. Correlation is significant at the 0.05 level (2-tailed).
Correlation analysis was built in order to test the linear relationship between various independent and dependent
variables used in this study
The above mentioned table shows the relationship between debt/equity ratio and return on capital employed
6.1 Interpretation

The above table shows the relationship between the variables Debt to equity, Debt to total funds, ROCE and
ROE.

The significance value or Sig(2-tailed ) value should be less than 5%, then there is relation otherwise there
is no relationship between variables.

The table shows there is significant relationship between Debt to total funds and ROE.

There is no relation or there is insignificance between debt to total funds and ROCE.
VII. HYPOTHESIS TESTING
HYPOTHESIS TESTING
No
Hypothesis testing
results
tool
H1
There is a positive relation between debt to equity and ROE
Rejected
correlation
H2
There is a positive relation between debt to equity and ROCE
Rejected
correlation
H3
There is a positive relation between debt to total funds and ROE
There is a positive relation between debt to total funds and
ROCE
Accepted
correlation
Rejected
correlation
H4
29 | P a g e
International Journal of Science, Technology & Management
Volume No.04, Issue No. 02, February 2015
www.ijstm.com
ISSN (online): 2394-1537
VIII. CONCLUSION
Several studies have been conducted on the examination of the impact of capital structure on profitability, but
there are mixed results in different conceptual frame work. Banks generally play a crucial role in the economic
development of every country. One critical decision banks face is the debt-equity choice. Among others, this
choice is necessary for the profit determination of firms. What this means is that banks that are able to make
their financing decision prudently would have a competitive advantage in the industry and thus making superior
profits. Nonetheless, it is essential for us to recognize that this decision can only be wisely taken if banks know
how debt policy influences their profitability. This study examined the relationship between capital structure and
profitability in SME The study covered SME, over the period of 2008 to 2013. The analysis of listed SME
shows that debt equity ratio is positively associated with all profitability ratios such as Return on equity and
Return on capital employed. Total debt was found to be significant in determining return on capital employed.
Debt to total funds ratio is positively associated with ROE it is significantly correlated to ROE. But with ROCE
and Debt to equity and ROE is negatively correlated.
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