IMPACT OF LEVERAGE ON FINANCIAL PERFORMANCE(EVIDENCE FROM PAKISTAN FOOD AND FERTILIZER SECTOR)

Abstract

The financial decision taken by the management regarding the optimal level of capital structure to maximize the wealth of the shareholder is very critical. In order to maximize the return to stockholders the managers make the use of debt and if the high amount of debt is used by the management it leads to increase the financial cost and financial risk of the firm. This study investigates the effect of three types of the degree of leverage, degree of operating leverage, degree of financial leverage and the degree of combined leverage on the financial performance of the firms of food and fertilizer sector registered under PSE. The sample of the study includes 20 listed companies for the time period 2008-2015. Some of the companies have been excluded because the data was not available for this study period. The statistical tests that were used in this study includes: descriptive statistics, correlation analysis, unit root test and random effect regression model. The measures like ROA (return on assets), EVA (economic value added) and Tobin’s were used to determine the firm’s financial performance. Since the financial performance of the firms is not only affected by the leverage therefore firm size has also been used in this study as a control variable. The result of this study reveal that the degree of financial leverage and combined leverage have not significant impact on the financial performance measured by return on assets but degree of operating leverage has negative significant impact on return on asset. Firm size also has no impact on the financial performance measured by ROA. Firm’s financial performance measured by the EVA (economic value added) is significantly and inversely affected by the DOL (degree of operating leverage) and DFL (degree of financial leverage). Performance measured by Tobin’s q is not significantly affected by DOL (degree of financial leverage), DFL (degree of operating leverage) and DCL (degree of combined leverage). Firm’s size has significant negative impact on the performance measured by Tobin’s Q. The results of this study supports to the pecking order theory of capital structure because firm’s performance measured in term of economic value added is significantly and negatively affected by the leverage. From the findings of the study it recommended that the managers of firms should control the fixed cost to avoid the operating leverage and focus to increase the revenue of firms. Moreover, the management should pay more attention to optimal level of debt and equity financing to avoid from liquidation and with technological advancement the firms needs to invest in more efficient and technologically advanced assets that will lead to improved efficiency. Instead of holding funds into large assets which are less profitable, it’s better for the firms to invest them in positive NPV projects.