Analyzing Relationship between Financial Leverage and Firmss Performance: A Case of Pakistan Textile Industry (2008-2013)

Abstract

This research of the relationship of firms’ financial leverage with firms’ performance is based on six year (2008-2013) financial record of 151 textile companies. The net profit before tax (NPBT) has been used as proxy to represent the firm profitability while total debt as a ratio of total equity has been defined as financial leverage. Of the total, 17 firms (11%) have been found with negative NPBTs, 36 firms (24%) have positive NPBTs and 98 firms (65%) have mix NPBTs (having positive for some years and negative for some years). The trend analysis suggests that on average financial leverage of negative NPBT yielding firms remained at -28.756 and increased by 2.747 every year during the period of 2008 to 2013. While the average leverage of mixed NPBT yielding firms remained positive at 1.939 and increased by 0.174 every year, and the average leverage of positive NPBT yielding firms remained at 1.547 and decreased by 0.007 every year during the studied period (2008-13). Leaving negative NPBT yielding firms aside, the average leverage of mixed NPBT yielding firms is higher (1.939) and has been being increased (0.174 per year) while that of positive NPBT yielding firms is relatively lower (1.547) and has decreased (0.007 per year). Separating all negative equity and negative NPBT bearing observations, we are left with 519 positive equity positive NPBT yielding observations. The mean value of leverage (L) of these observations is estimated at 1.8338 and ranged between a minimum and maximum of 0.03 and 9.65. The mean value of NPTA (NPTA = NPBT/Total Assets) estimates at 0.0725 and ranges between minimum and maximum values of 0.0001 and 0.3233. For measuring a mathematical relationship between NPTA and L, the former variable was regressed over the latter, using three formulations (Linear form: NPTA = β0 β1L; Quadratic form: NPTA = β0 β1L β1L2; Cubic form: NPTA = β0 β1L β1L2 β1L3). The linear and squared form of the model gave good results; the cubic model yielded insignificant results. The results in the linear form (NPTA = 0.102 – 0.016L) suggest that there is an inverse relationship between leverage and profitability; for every one unit of leverage (L) increase, profitability (NPTA) decreases by 0.016 units. The results of the Quadratic form are reproduced, as follows: NPTA = 0.122 – 0.036L 0.003L2. Taking the F.O.C, and solving for L helps us estimate L = 6. These results suggest that with L = 0, the NPTA estimates at 0.122 (net profits are 12.20% of total assets) and with L = 6, NPTA minimizes at 0.014 (net profits drops to 1.40%). The existence of statistically significant inverse relationship between firms’ profitability and financial leverage persuades one to recommend that financial leverage be kept and managed as low as possible for greater firms’ profitability.