Effect of Capital Structure on Firms’ Profitability: An Empirical Evidence from Pakistan Stock Exchange (PSX)

Abstract

This paper examines the impact of capital structure on firms’ profitability. In order to examine the relationship, we used annual panel data for 20 non-financial firms listed at Pakistan Stock Exchange during 2009 to 2015. The panel econometric technique used to explore the effect of capital structure on firms’ profitability is ordinary least squares (OLS). Each multivariate regression model incorporates two independent and one dependent variables.

The empirical findings showed that debt to equity has significant impact on return on equity and insignificant on net profit margin and return on asset. However, debt to asset has insignificant impact on return on equity and significant on net profit margin and return on asset. It concludes that performance of an organization is sensitive to the type of capital structure the firms adopt, hence, capital structure has significant influence on profitability. Therefore, managers should consider effect of debt on firms’ profitability earlier to adjusting debt levels in the capital structure. Moreover, the lenders tenderly inflict the debt covenants considering their impact on firms’ profitability. Hence, an optimal level of debt and equity should be incorporated in the capital structure in order to attain the targeted level of efficiency and success in business performance.

Keywords: Panel regression, Capital Structure, Financial Performance, OLS.

JEL CODE: D22, G32