IMPACT OF LEVERAGE AT FIRM PERFORMANCE IN

MANUFACTURING INDUSTRY OF PAKISTAN

By

Rabia Ilyas

A Research Project submitted to the Department of Management Sciences, Government

College University, Faisalabad, Pakistan

Class: MBA- Management Sciences

Session: 2012-2016
Title Page
 Dedication

I dedicate this research project to my late parents, brothers, sisters, cute nephews, nieces and
beloved friends.

This research project also dedicated to my supportive colleagues of office also .

 Declaration

I, Rabia Ilyas, declare that the my MBA Research Project entitled “Impact of Leverage at Firm
Performance in Manufacturing Industry in Pakistan” is no more than 10000 words and contains
no material that has been submitted previously, in whole or in part , for the award of any other
academic degree or diploma, except where otherwise mentioned, this thesis is my own work.

Signature: _______________ Date: _______________

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Accordance with the prescribed format. We recommend it to be processed for the evaluation by

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 Acknowledgment

This Research Project would have not been possible to make without the support of numerous
people, whom I wish acknowledge.

First, my deepest gratitude goes to may supervision, Maim Sonia, for her commitment,
invaluable supervision, scholarly support and dedication of time, without which this project
would not have to become reality.
Secondly, I am thankful to my teachers, Dr. Nadeem Iqbal, Sajid Iqbal, Naveed Irshad for their
scholarly support and commitment and motivation.

I could not have completed this project without the support of my beloved family members and
friends also

I could not have completed this journey without the love and friendship of my family

And friends.

Abstract/Executive Summary

This study presents an empirical insight into the relationship between leverage and firm
profitability .Short term debt and long term debt were considered as leverage variables .Firm
profitability is measured using return on equity(ROE) and return on assets (ROA).For this
purpose 1 cement firm have been listed on Pakistan Stock Exchange during the time period
2010-2014 and the regression model and descriptive statistics have been used in order to test the
hypotheses.

Table of Contents
Chapter # 1: Introduction

1.1 Background/Context

One of the most important reference theories in enterprises financing policy is the theory of
capital structure and various studies use capital structure theory to highlight the significance of
debt financing. Capital structure of a firm is defined by its leverage; that is a mix of debt and
equity financing which is subject to different financial difficulties. One crucial issue confronting
managers today is how to choose the combination of debt and equity to achieve optimum capital
structure that would minimize the firm’s cost of capital and improves return to owners of the
business. According to previous studies, financial leverage affects cost of capital, ultimately
influencing firms ’profitability and stock prices (Higgins,1977; Miller,1977; Myers,1984)
The trade-off theory states that a firm selects how much debt finance and equity finance it needs
to employ by evaluating the costs and benefits of each type of finance. Certainly such preference
is not contemporary it is rather familiar to researchers and managers (Butters 1949). In this
theory, the management of the firm must assess the different types of costs and benefits of the
optional leverage strategy and must aim at a level of debt to value, such level is depends on
establishing a balance between debt tax shields and costs of bankruptcy (Myers (1984)).
The earnings are independently and identically distributed, so the leverage remains same in each
period (Scott, 1976). Optimal level of leverage generally decreases business risk become the
cause in increase in profits (Raymer, 1991). The free cash flow indicators, inadequate valuable
investment opportunities, considerable and sustainable cash flows and high level of
diversification are outcome of leverage (Jensen, 1986).Gibbs (1993) the relationship between
financial leverage and financial performance is positive and significant. The relationship between
leverage and size of firm as it is a general perception that the likelihood of larger firms to be
diversified is more as they can access to the capital market easily and may benefit from the
higher credit ratings (Ferri and Jones, 1979). Zwiebel (1992) argued that every type of leverage
positively affects profits of company.
Leverage refers to the extent to which firms make use of their money borrowings (debts
financing) to increase profitability and is measured by total liabilities to equity. Firms that
borrow large sums of money during a business recession are more likely to default to pay off
their debts as they mature; they will end up with high leverage and are more likely end up with a
potential risk of bankruptcy. On the contrary, the lower the firm's borrowings, the lower the
leverage, and the risk of bankruptcy will eventually be lower which signifies that business will
continue operating.
In the business research the major objective of the researcher is to study the factors that can
affect positively or negatively to the firm profitability. It has been claimed by many researchers
that the leverage is top most secret to increase the firm financial performance and can affect
significantly to financial improvement of firms.
Bernanke Campbell and Whited (1990) investigated and found that restructuring activity shall
have dominant affect at firm performance. Fama and French (1992) recommended that there is
price of distressed risk as a high discount rate may be used for the contribution of firm with high
leverage in financial distress. On the other hand, Harris and Raviv (1988) recommended that
encouraging motives can compel managers to increase leverage beyond the optimal point
because they want to increase financial profits of firm. The encouragement of limited liability
stakeholders to raise the risk of firm by increasing leverage has been extensively noted (Galai
and Masulis,1976).
It comprises the capital structure management concepts. Manager choice of making debt
intensive or equity intensive company that formulate the financing of the company assets leads
to the concept of capital structure formulation. It has been observed that most of the managers of
company use some extent of dept and some extent of equity to finance their assets and assets are
used to generate profits. In the past, numerous of studies have been conducted on the market and
book value measured of leverage as (Jnag, 2005, Titman and Wesseles, 1998; Rajan and
Zingales, 1995).
Leverage induces cost of capital, at lost incline firm profitability and stock price (Miller, , 1977;
Myres, 1948 and Sheel, 1944). If the interest on debt is less than the return from debt, firm
should take debt (Mandelker and Rhee, 1984). If return on assets is greater than the before tax
interest rate paid on debt that we can say that leverage is positive. If return on assets of the firm
is less than before tax interest rate than we can say that leverage is negative (Larry and Stulz,
1995).

1.2 Problem Definition

The concept of Leverage is not clear to many stakeholders. It needs to understand the concept
of every type of leverage according to the context of Pakistan. Businesses are often unaware
from the concept of Leverage. Some stakeholders are unfamiliar with the concept of Leverage
also. Companies are unaware with the impact of Leverage at financial performance. In
developed countries, a lot of study has been conducted at the topic of leverage but there is lack
of research on the relationship between leverage and financial performance in developing
countries like Pakistan. There is also an ambiguous relationship between leverage and Financial
Performance. Because many writers and scholars have diverse point of view at the relationship
of Leverage and Financial Performance.

Pakistan is a developing country and majority of Pakistani firms are unfamiliar with the concept
of leverage. The level of understanding is also not very high in Pakistan regarding association of
leverage of with financial returns

Different scholars holds different concept about leverage and provides different relations
between leverage and firm performance. It leads to the conflicting and disputing situation.
There is also a lack of unity of opinion among researchers regarding the relationship between
leverage and financial performance. Because, some researchers believes that there is positive
association between leverage and financial performance but some researchers believes that
there is negative or null association between leverage and financial performance.

1.3 Research Objectives/Research Questions

As discussed earlier in introduction and research problem section, there is less importance is
given to like studies in under-developed and developing countries like Pakistan. There is also a
lack of understanding of leverage in Pakistan and diverse point of view of different researcher
at the relationship between leverage and financial performance. That is why following research
questions take birth regarding this study,

i) What is the concept of leverage in Pakistan?

ii) Is there a Relationship between Leverage and Financial Performance?
iii) What is the most acceptable definition of Leverage?
 iv) Is there a Positive Relationship between Leverage and Financial Performance?
v) Is there a Negative Relationship between Leverage and Financial Performance?
vi) Is there a Neutral Relationship between Leverage and Financial Performance?

1.4 Research Objectives

The prime objective of this study is to investigate the relationship between leverage and firm’s
Financial Performance. Furthermore, this study seek the impact of leverage at Financial
Performance that leverage of company positively impacts its financial performance or
negatively. However, after reading the above mentioned research questions and section of
research problem, following objectives of this study exists,

i) To explore the state of leverage in Pakistan.

ii) To investigate the relationship between leverage and Financial Performance that
whether leverage positively affects Financial Performance or negatively.
iii) To provide a definite, concrete and globally acceptable definition of leverage.
iv) To clear the concept of leverage to stakeholders.
v) To increase the level of understanding regarding leverage in Pakistan.

1.5 Research Gap

The domain of leverage regarding Financial Performance is widely investigated and rich in
developed countries like as USA, UK, and Germany but very limited research has been
conducted at leverage and Financial Performance in developing countries like India, Bangladesh
and Pakistan. The previous studies have been conducted by using small amount of sample at this
topic.

Chapter # 2: Preliminary Details

2.1 Literature Review

A lot of research has already been conducted on the impact of financial leverage on firm
profitability. Titman & Wassels (1988) concluded in his study that firms which use their earnings
instead of taking outside capital earn more profit because of less leverage as compare to the firms
which rely more on outside capital which increase their leverage.
Firm performance can be depicted by the price of its stock. If stock price of the firm is high than
firms prefer to issue equity instead of taking outside capital that helps them to maintain their
leverage. Wald (1999) in his research study argued that debt to assets ratio has significant
negative relation with the firm profitability.
He did his study on the firm’s capital structure which operates in United State, United Kingdom,
Japan, France, and Germany. He used firm size, growth and firm’s riskiness as explanatory
variables.
Sheel (1994) in his study also supported the negative relation between debt to assets ratio and
firms past profitability. He used cross sectional regression analysis to study the leverage behavior
of 32 firms in two industry groups, Hotel industry and manufacturing sector was examined. His
findings confirmed that all leverage determinants except firm size are significant in explaining
leverage variations in debt behavior. . The aim of this study was to analyze the association
between financial leverage and restaurants firm profitability and risk.
For the sake of the achievement of objective of this study, he made three hypotheses. The first
hypothesis was restaurant firms using a lower level of financial leverage have higher
profitability. If a restaurant firm has a higher level of financial leverage than it has to spend large
amount as interest expense despite the business situation.
Second hypothesis was; firms with a higher level of financial leverage are riskier than those with
a lower level of financial leverage. In his study he applied return on equity as a measure of
profitability and financial leverage as a ratio of long term debt to total assets and total assets as
firm size. Results of the study suggested that the restaurant firms having large assets were more
profitable than small firms and the sign of financial leverage variable was negative which
indicated that firms with higher debt rates were less profitable.
Mandelker & Rhee (1984) explained that the most profitable firm in many industries often have
the lowest leverage ratio also found that large positive abnormal returns for a firm’s stockholders
are associated with leverage increasing events such as a stock repurchase or debt for equity
exchange instead of leverage decreasing events such as issuing stocks. In contrast to the trade off
theory, the pecking order theory of capital structure states that firms have a preferred hierarchy
for finding decisions.
The highest preference is to use internal financing such as retained earnings before restoring to
any external funding. If a firm uses external funding the order of preference is debt, convertible
securities, preferred stocks and common stock (Myers, 1984). Most studies of capital structure
used a basic assumption of trade off theory. After selecting an optimal combination of financing
which could be the combination of debt and equity way to gathering funds that deliver the tax
benefit given by the debt which increased costs of financial distress to the equity holders of the
firms. Firms need to have the target structure of capital.
Larry & Stulz (1995) conducted a study on the effect of debt on firms in Ghana which resulted
positive significant association between total debt and total assets and return on equity. A study
carried out by Murphy (1968), on financing behavior of listed Chinese firms resulted in a
conclusion that a negative relationship between profitability and firms leverage exists. A higher
rate of return on equity capital should produce in turn more rapid growth of earnings and
dividends and higher valuation of the common stock.
The return on equity capital, growth of earnings and dividends and the market’s valuation of the
firm’s common stock are all directly tied to the leverage as far as theory is concerned. It is
revealed that proportion of leverage in
a firm’s capitalization would be directly related to its relative return on common equity, growth
of earnings, price appreciation and market valuation. Leverage also had no appreciable effect on
market valuation.
The long term debt to total capital ratio was generally unrelated to a firm’s relative price to
earnings ratio and to dividend yield on its common stock in all industries and all time periods.
There were some tendency to the market to value highly leveraged companies at lower rather
than higher prices in terms of price to earnings multiple and dividend yields.
If a company issues debt it provides a signal to the markets that the firm is expecting positive
cash flows in the future. The principal and interest payments on debt are fixed contractual
obligation which the firm has to pay out of its cash flows. Therefore, higher level of debt shows
the manager confidence in future cash flows. Another impact of the signaling factor is the
peeking order theory is the problem of the under pricing of equity. If a firm intends to issue
equity instead of debt for financing future projects the investors will interpret the signal
negatively. Since managers have superior information about the firm than investor they might
issue equity.
Deloof (2003) analyzed and understand the impact of leverage on the profitability of the firm by
investigating the relationship between the leverage and the earning per share. Leverage in three
ways which were financial leverage, operating leverage and combine leverage the hypothesis of
relationship between degree of financial leverage and earnings per share. Operating leverage is
caused due to fixed operating expenses in a firm. It is the firm’s ability to use fixed operating
costs to magnify the effects of changes in sales on its earnings before interest and taxes.
Financial leverage is caused due to fixed financial costs in firm. It is the ability of the firm to use
fixed financial charges to magnify the effects of change in EBIT on the earning per share. It
involves the use of funds obtained at a fixed cost in the hope of increasing the return to the
shareholders. Shin Soenen (1998) undertook a study on leverage and financial performance at
listed firms of Malaysia and found that there is positive relationship between leverage and
financial performance of firms.
There is negative association between debt to assets ratio and firms past profitability (Sheel,
1994). Debt to assets ratio has significant relation with the firm profitability (Wald, 1999). Eunju
and Soocheong (2005) conducted a study on relationship between leverage and financial
performance and firm size and concluded and that the firms which have larger assets are more
profitable than smaller businesses with lack of assets. A study has been conducted on listed firms
of china by (Murphy, 1968) and found negative relationship between leverage and firm financial
performance. If a company issues debt that will result in good future cash flows and it positively
affects profitability of company (Gupta, 1969).
Amsaveni (2009) leverage and financial performance, he found that there is negative relationship
between leverage and financial performance. Mangalam and Govindasamy (2010) examined and
understand the impact of leverage of profitability. They analyzed the leverage in three ways
operating, financial and total leverage. They found positive association between each type of
leverage and firms profitability. Padachi (2006) conducted a research between leverage and
profitability and found that there is negative association between leverage and profitability.
The financial leverage employed by the company is intended to earn more return on fixed charge
funds than their costs. There is a close relation exists between the financial leverage and earnings
per share of the company. If degree of financial leverage is high and the return on investment is
greater than the cost of debt capital, then the impact of leverage on EPS will be favorable. Nasr
(2007) analyzed profitability and leverage of 94 firms listed at Karachi stock exchange and found
that there is negative relationship between leverage and financial performance. The impact of
financial leverage is unfavorable when the earning capacity of the firm is less than what is
expected by the lender.
The results suggest that there is a significant negative relationship exists between financial
leverage and earnings per share. The leverage effect is positive when the earnings of the firm are
higher than the fixed charges to be paid for the lenders. Uyar (2009) and conducted a study to
found the relationship between leverage and financial performance and found that there is
negative association between leverage and financial performance. The leverage is an important
factor which is having impact on the profitability of the firm and the wealth of the shareholders
can be maximized when the firm is able to employ more debt.

2.2 Conceptual Framework & Hypothesis Development

2.3 Conceptual Theoretical Framework

Much of the existing research is about exploring the relationship between Leverage and Financial
Performance. The vague and unclear framework of Leverage and less acceptable measurement practices
are the limitations of these studies. Further, majority of these studies are undertaken in developed
countries. The major objective of this study is to examine the relationship between Leverage and
Financial Performance within the context of developing countries like Pakistan. This study is an effort to
develop a framework which can be applied universally.

This section of the research project is about the development of Conceptual Theoretical Framework of
the study. The Conceptual Theoretical Framework which is also known as Model contains different
variables of the study. It provides basis to understand the effect of different independent variables on
dependent variables. It also throws light on control variables of the study. The conceptual framework
indicates the interaction between Leverage which is the only the independent variable of the study and
financial performance variables which are the dependent variables of this study.

2.3.1 Independent Variables of the Study

This study emphasizes the organizations to invest more and more in capital assets to improve
their profitability. Therefore, this study is about the Leverage variable which can significantly
affect the financial performance of companies. The leverage is the independent variable of the
study which contains two sub independent variables which are long term debt and short term
debt.

2.3.2 Dependent Variables of the Study

The effect of leverage is examined at profitability and profitability is measured in terms of

Return on Assets (ROA) and Return on Equity (ROE) which are the dependent variables of the
study.

Leverage FP

STD ROE

LTD ROA

IVs DVs

2.4 Hypothesis Development

H1: There is positive association between Leverage and Financial Performance (FP)

H2: There is positive association between Short Term Debt (STD) and ROE & ROA
H3: There is positive association between Long Term Debt (LTD) and ROE & ROA

Chapter # 3: Research Design/Methodology

Chapter # 4: Results

4.1 Descriptive Results

4.2 Hypothesis Acceptance/Rejection

Chapter # 5 Discussion

Chapter # 6 Conclusion

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