IMPACT OF CAPITAL STRUCTURE ON FINANCIAL PERFORMANCE: A STUDY ON LISTED MANUFACTURING COMPANIES IN SRI LANKA
Abstract
The determination of a company’s capital structure constitutes a difficult decision, one that involves several and opposed factors, such as risk and profitability. That decision becomes even more difficult, in times when the economic environment in which the company operates presents a high degree of instability. Therefore, the choice among the ideal proportion of debt and equity can affect the value of the company and return rates. This paper empirically investigated the relationship between capital structure and the financial performance of manufacturing sector of Sri Lanka, by using panel data extracted from the financial statements of the companies listed on the Colombo Stock Exchange. The rational behind the industry specific analysis was the fact that exogenous variables appear to force firms in the same industry in similar fashion, thus leading to the existence of an industry specific capital structure. Firms’ financial performance was measured in terms of accounting profitability by Return on Equity (ROE). Panel data were analyzed using Ordinary Least Squares (OLS) as a method of estimation. It was found that first there was no significant relationship between the short-term debt and profitability, second statistically significant negative relationship between long-term debt and fitability finally total debt had significant negative relationship with firms’ financial performance, which tends to sport the dominant pecking order theory. The results revealed consistency with prior empirical studies and provides evidence in support of Agency cost theory also. Firm's age and size had considered as two control variables on the performance scales. Firm size positively influenced financial performance and there was no clear evidence to impact the companies’ age on performance. The outcomes of the study may guide entrepreneurs, loan- creditors and policy planners to formulate better policy decisions in respect of the mix of debt and equity capital and to exercise control over capital structure planning and thereby to control and reduce bankruptcy costs. The future research work based on this study is also suggested as identifying the optimum capital structure that leads to higher performance in Sri Lanka.
Key Words: Capital Structure, Financial Performance, Listed Manufacturing Companies
