The relationship between leverage and profitability : A quantitative study of consulting firms in Sweden

Abstract

Profitability is fundamental for any firm to retain a competitive advantage and facilitate long-term prosperity. The drivers of profitability may depend on the industry, and the path to profit maximisation has been thoroughly discussed in previous research. A common factor included by researchers to determine firm profitability is capital structure. The results on the relationship between capital structure and profitability differ significantly depending on the context of the research. Furthermore, research on capital structure in the management consulting industry seems absent, which has left the authors of this study a research gap to fill. This study does through a quantitative method investigate the capital structure and profitability of 130 management consulting firms in Sweden during the years 2012-2016 by examining the relationship between leverage and profitability. Leverage is mainly constituted by total debt to assets, but also by short-term and long-term debt to assets. Profitability is defined as Return on Assets, which indicates how profitable firms are relative to total assets. To account for the aspects of profitability that are not captured by leverage, control variables including size, liquidity and age are also tested. The establishment of hypotheses is based on the theoretical frame of reference which includes the theories of Modigliani and Miller, the trade-off theory and the pecking-order theory. The study utilises several statistical models including OLS, Fixed Effects and Robust Fixed Effects. From generated results, it becomes evident that the modelling has a considerable impact on the outcome. However, the improved modelling is believed to generate more robust results and corresponding conclusions, which is an improvement compared to methods widely used in previous research. To account for reversed causality, tests of the relationship between last year’s leverage and the current year’s profitability have been conducted. The statistical analysis shows that leverage has a significant negative relationship with profitability. This is in line with the pecking-order theory, implying that firms mainly use internal financing over external financing to achieve higher profitability. Profitable consulting firms also tend to use less short-term and long-term debt, according to the results. Moreover, the results show that larger firms in terms of employees generally are more profitable. For age and liquidity, no overall conclusive relationship with profitability could be found. Lastly, the results show a positive relationship when including last year’s debt ratios but is only significant for long-term debt.

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