Impact of Capital Structure on the Financial Performance of Firms: A Study of BSE Listed Selected Pharmaceutical Companies

Jibin J Varghese^* and Sanjay Sahai
^*Correspondence: Jibin J Varghese, Department of Management, Christ University, Pune, India, Tel: 9746117286, Email:

Keywords

Capital structure • Profitability ratios • Financial performance

Introduction

The capital structure of a company lays the basis for the capital cost of the company. The costs of debt and equity depend on the market conditions prevailing and the choice the company exercises impacts its performance over the long term. The factors that influence the company’s decision include the nature of its business, its reputation, the gestation period of its project, and the expected pattern of its cash flows. Given the cost differential between debt and equity and the tax benefits associated with debt, the capital structure decision will influence the company's performance. The capital structure is also influenced by the sector in which the company is operating. Keeping this in view, an attempt has been made in this paper to examine the relationship between a pharmaceutical company's capital structure and its financial performance. It will help the manager to make appropriate decisions on constructing a proper capital structure for a company. The recent Covid-19 outbreak proved that pharma companies are compelling for long-term investors. This study would help those who wish to invest in pharma companies and the companies' management to review their capital structure decisions.

Literature Review

Goyal studied the significance of capital structure on the performance of Public sector banking from 2008 to 2012. The study stated a positive relationship between the short-term debt to capital ratios on all the profitability ratios and a negative relationship between Loner term debt to capital ratio and profitability ratios such as ROA, ROE, and EPS of the Indian Public sector banks.

Taani evaluates the relationship between capital structure and performance of 45 listed manufacturing companies in Amman stock exchange, Jordan. The study found that the capital structure is not an essential factor in a firm's financial performance using multiple linear regression analysis. The study used Return on Assets and Profit margin as performance indicators, long-term debt to total assets, Short-term debt to total assets, and Total debt to Equity as capital structure variables used Return on Assets and Profit margin as performance indicators, long-term debt to total assets, Short-term debt to total assets, and Total debt to Equity as capital structure variables.

Nirajini analysis using a simple regression method shows that the capital structure has a positive relationship and significant impact on trading companies' financial performance in Sri Lanka. Further, the study found that there exists a correlation between debt asset ratio, debt-equity ratio, long term debt with a Gross Profit Margin (GPM), Net Profit Margin (NPM), Return on Capital Employed (ROCE), Return on Asset (ROA) and Return on Equity (ROE) Mumtaz worked on the sample data of 83 private companies from the listed firms on the Karachi Stock Exchange (KSE). The considered sample of data has been analyzed through regression techniques. The study suggests that the capital structure significantly impacts firms' financial performance and negatively relates to financial performance. Moreover, the capital structure of a firm has a negative relationship with its market value. It also increases the risk level as the share of debt increases in the capital mix Jawade focused on Indian Pharmaceutical companies based on Market capitalization. It found that the companies are very cautious about the optimal selection of capital structure. Pharma companies under the study have not shown any inclination for the Pecking order theory. Based on a sample of six pharmaceutical companies, the research found that these companies were conservative in their approach to capital structure decisions despite their financial strength.

Movalia examined the capital structure and profitability of selected Indian tyre companies. This study used Durbin Watson Statistics for testing the developed hypotheses. Significant companies like MRF, Apollo Tyres, Dunlop India, and Modi Rubber showed a positive relationship between capital structure and financial performance Nawaz investigated the significance of financial leverage on cement manufacturing companies' profitability in Pakistan using the ordinary least square simple regression model. Data for six years of a sample of 18 cement firms listed on the Karachi Stock Exchange (KSE) was considered and analyzed using the Ordinary Least Square Simple Linear Regression technique. For this technique, the dependent variable is profitability (ROA), and the independent variable is financial leverage. The study accepted the hypothesis that there is a negative relationship between financial leverage and profitability ratio (i.e.,) ROA.

Bhatnagar and Dr. Vinod shows a significant relationship between capital structure and profitability. This study considered five companies such as Dabur, Emami, Everest, Godrej, and ITC, and analyzed the data using the simple linear regression technique.

Basit stated that the independent variable ‘debt to equity ratio’ was significantly correlated to dependent variables such as earnings per share, return on equity, and return on assets. The study used data from 50 Pakistani companies from different sectors such as Chemical, Food, and Care products, Cement, Pharmaceutical, Auto assembler, and Textile. Hypothesis testing was done using the Pearson correlation coefficient and the multiple linear regression model.

Das identified the determinants of capital structure and analyzed the impact of capital structure on financial performance. Data of 50 manufacturing companies for ten years was considered to examine the impact of capital structure on financial performance as reflected in Return on Equity (ROE), Return on Asset (ROA), Return on Capital Employed (ROCE), and Earning per Share (EPS). The capital structure was quantified using the Current Ratio (CR), Long term debt to Total Assets (LD_TA), Total Debt to Total Assets (TD_TA), and Debt Equity Ratio (DER). Multiple Regression was employed to analyze the impact of capital structure on financial performance. The study finds a significant relationship between ROA, ROE, ROCE, and Capital Structure variables. One of the hypotheses, which stated a relationship between EPS and Capital Structure variables was rejected.

As a study has not been conducted on the impact of capital structure on financial performance of pharmaceutical companies, this paper proposes to conduct this analysis.

Research Problem and Methodology

The study's main objective is to analyze the impact of capital structure on the selected pharmaceutical company’s financial performance. Moreover, to analyze whether the capital structure, which is seen in terms of various ratios like Debt Equity Ratio, Debt Ratio, and Equity Ratio has a negative or positive relationship between the financial performance that is measured using the ratios such as Return on Equity, Return on Assets, Net Profit Margin the relationships between these variables have also been studied. Drawing from the literature given above, the sample data analysis is done through correlation analysis and multiple linear regression using the R Programming language.

About the dataset used

For this study, a sample of 20 BSE listed Pharmaceutical companies are taken based on market capitalization over a period from 2016 to 2020. The data has been taken from the website of money control.com and the selected pharmaceutical companies' annual reports. The average of all the ratios is calculated and considered for the study.

Table 1 shows the selected BSE listed Pharmaceutical companies for the study.

Table 1: List of selected companies.

Variables: The independent variables used for the study are debt-equity ratio, debt ratio, and equity ratio, and dependent variables as Return on Assets, Return on Equity, and Net Profit Margin.

The Debt-Equity Ratio is a measure of capital structure, and it is calculated using the following formula:

• Debt-equity ratio=Long term borrowing/Shareholders fund.

The debt ratio can be calculated by dividing the Long-term borrowings with Total assets:

• Debt ratio: Long term borrowings/Total assets

The equity ratio measures the relative proportion of equity used by a company for financing its assets, which can be calculated by the following formula:

• Equity ratio: Shareholders fund/Total assets

Net profit margin shows the profitability of the company. The following is the formula for calculating net profit margin:

• Net profit margin: Net profit/total revenue

ROE and ROA measure the financial performance of a company. It can be calculated using the following formulas:

• Return on Equity: Net income/Shareholders fund

• Return on Assets: Net income/total assests

Research hypothesis testing

Following are the hypotheses developed to investigate the effectof capital structure on financial performance.

H₁-There is a negative relationship between Debt Equity Ratio and Profitability Ratios (ROE, ROA, Net Profit Margin)

H₂-There is a positive relationship between Debt Ratio and Profitability Ratios (ROE, ROA, Net Profit Margin)

H₃-There is a positive relationship between Equity Ratio and Profitability Ratios (ROE, ROA, Net Profit Margin)

H₄-Capital Structure has a significant relationship with the financial performance of pharmaceutical companies.

Model specification

Multiple linear regression is used to estimate how strong the relationship is between capital structure ratios such as Debt Equity Ratio, Debt Ratio, Equity Ratio, and profitability ratios such as ROE, ROA, and Net Profit Margin, which measures the financial performance of the pharmaceutical companies. Three of the regression models are formulated to check the relationship between capital structures and financial performance of the pharmaceutical companies, which forms the following equations:

ROE=β₀+β₁ (Debt. Equity. Ratio)+β₂ (debt. Ratio)+β₃ (Equity. Ratio)+ε ROA=β₀+β₁ (Debt. Equity. Ratio)+β₂ (debt. Ratio)+β₃ (Equity. Ratio)+ε Net Profit Margin=β₀+β₁ (Debt. Equity. Ratio)+β₂ (debt. Ratio)+β₃ (Equity. Ratio)+ε(Equity. Ratio)+ε

Where: ROE, ROA and Net Profit Margin are dependent variables Debt. Equity. Ratio, Debt. Ratio, Equity. Ratios are independent variables. β0-Intercept term; ε – Error terms.

Findings and Conclusions

Correlation analysis shows a negative relationship between capital structure as reflected in Debt Equity Ratio, Debt Ratio, and financial performance as reflected in the Profitability Ratios (ROE, ROA, Net Profit Margin). Further, the analysis shows a positive relationship between Equity Ratio (Capital structure) and Profitability Ratios (ROE, ROA, Net Profit Margin). So, hypothesis H₁ and H₃ are accepted, i.e., failed to reject, and H₂ has been rejected. The first regression analysis model showed that each of the capital structures is not statistically influenced by ROE as profitability ratio, which is a cause of the pharmaceutical companies' financial performance. The second and third model shows that each of the capital structures is statistically influenced by ROA and Net Profit Margin as profitability ratio, which is also a measure of the listed pharmaceutical companies' financial performance. So, hypothesis H₄ is rejected in the case of the first model and accepted (failed to reject) in the second and third regression models.

Measuring growth and profitability is one of the primary goals of a business entity. The study's principal objective was to measure the impact of capital structure on selected pharmaceutical companies' financial performance. This study indicates that the composition of debt and equity in a firm's capital structure is a significant managerial decision. It can impact the firm's performance, and it can also influence the shareholder's interest.

References

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