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This study examines the effect of debt financing on firm’s financial performance, measured as return on equity, using panel data of 95 textile companies in Pakistan from 2002-03 to 2007-08. Empirical results show a nonlinear relationship between return on equity and debt-to-asset ratio. As the debt-to-asset ratio increases, initially the return on equity increases until an optimal debt level is reached, after that it starts decreasing. The optimal debt-to-asset ratio for Pakistan’s textile firms is estimated as 56 percent. We also find that firm’s sales growth has positive and significant impact on return on equity whereas the firm size has no significant impact on it.
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