The Effect of Capital Structure on Profitability: Evidence from the United States

Abstract

The relationship between capital structure and profitability cannot be ignored because the improvement in the profitability is necessary for the long-term survivability of the firm. This paper seeks to extend Abor's (2005) findings regarding the effect of capital structure on profitability by examining the effect of capital structure on profitability of the American service and manufacturing firms. A sample of 272 American firms listed on New York Stock Exchange for a period of 3 years from 2005 - 2007 was selected. The correlations and regression analyses were used to estimate the functions relating to profitability (measured by return on equity) with measures of capital structure. Empirical results show a positive relationship between i) short-term debt to total assets and profitability and ii) total debt to total assets and profitability in the service industry. The findings of this paper show a positive relationship between i) short-term debt to total assets and profitability, ii) long-term debt to total assets and profitability, and iii) total debt to total assets and profitability in the manufacturing industry. This paper offers useful insights for the owners/operators, managers, and lending institutions based on empirical evidence. Introduction The capital structure decision is crucial for business organizations. The capital structure decision is important because of the need to maximize returns of the firms, and because of the impact, such a decision has on the firm's ability to deal with its competitive environment. The capital structure of a firm is a mixture of different securities. In general, firms can choose among many alternative capital structures. For example, firms can arrange lease financing, use warrants, issue convertible bonds, sign forward contracts or trade bond swaps. Firms can also issue dozens of distinct securities in countless combinations to maximize overall market value (Abor, 2005, p. 438). A number of theories have been advanced in explaining the capital structure of firms. Despite the theoretical appeal of capital structure, researchers in financial management have not been able to find a model for an optimal capital structure. The best that academics and practitioners have been able to achieve are prescriptions that satisfy short-term goals (Abor, 2005, p. 438). The lack of a consensus about what would qualify as optimal capital structure in the sendee and manufacturing industries has motivated us to conduct this research. Abetter understanding of the issues at hand requires a look at the concept of capital structure and its effect on the firm's profitability. Most other empirical studies on the capital structure of the firm and profitability have been conducted on industrial firms. There might be other factors that affect the profitability of service firms, which are not involved in manufacturing. In service industry, investment in machinery and equipment is very low. If service firms lease their facilities (buildings), then their total capital invested is mainly working capital (Gill, Biger, and Bhutani, 2009, p. 48). In order to examine whether these different investment patterns are also related to the capital structure of these firms, we chose to sample companies from both service industries and manufacturing. This study examines the relationship between capital structure and profitability of the American service and manufacturing firms. The literature cites a number of variables that are potentially associated with the profitability of firms. In this study, the selection of exploratory variables is based on the alternative capital structure, profitability theories and previous empirical work. The choice can be limited, however, due to data limitations. As a result, the set of proxy variables includes six factors: three ratios of short-term debt to total assets, long-term debt to total assets, total debt to total assets and, in addition, sales growth, firm size, and profitability (measured by return on equity). …

Cite this work

No public copy is stored for this record, so only the metadata is cited.

Stored only when both papers are in the corpus — 270 citations exist upstream.