Impact of financial leverage on firm performance: with special reference to manufacturing sector in Sri Lanka
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Date
2015
Journal Title
Journal ISSN
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Publisher
Uva Wellassa University of Sri Lanka
Abstract
Capital structure plays a crucial role in enhancing performance of firms, by helping financial
manager to select optimal mix of debt and equity to give required rate of return for shareholders.
Generally, due to great cost of capital within the equity and tax advantage of debt, leverage
consider as the optimal solution for a company, to gain financial resources. Therefore research is
going to identify impact of financial leverage to the performance of firms within Sri Lankan
context.
According to the Akhtar et.al (2012) leverage is consider as proportions of borrowing funds from
outside sources. Through past decades, various theories set the foundation to optimize the debt
financing usage in organizations. Warne and Rasoolpur (2013), mention that the greater use of debt
will increases the net return to the equity shareholders. Moreover, Akthar et.al (2012) stated that
leverage may enhance the profit after taxes; due to lower interest rates .Then eventually the higher
earnings of firm will result to the higher earnings per share and then these higher dividend payout
ratios which may increase the firm’s performance. Duties of owners (shareholders) and managers
are different in every organization. Due to that, management is more concern about personal gains.
This may cause conflict situations within organizations. For that debt finance act as a control tool to
restrict the opportunistic behavior of managers. On the other hand, Usage of debt is tradeoff
between risk and return. Risk of the firm increase simultaneously with increasing leverage and
leads towards liquidations and takeovers. Moreover, unbalanced debt will cause to financial
distress cost and bankruptcy cost.
Therefore, this research aims to investigate this scenario within manufacturing industry in Sri
Lanka. Accordingly, objectives of research were concluded, to examine the relationship of firm
performance with short term debt (STDA), long term debt (LTDA) and total debt (TDA)
respectively.
Methodology
Research was conducted regarding the Colombo Stock Exchange and population consists with
manufacturing industry in Sri Lanka. 30 companies were used for the analysis. Data was collected
through secondary data sources such as annual reports of companies through 5 years. Further,
leverage was measured by using Long -Term Debt Ratio (LTDA), Short- Term Debt Ratio (STDA),
Total Debt Ratio (TDA) which were used by Musiegaeth.al (2013) and Abort (2008). Firm
performance proxy by Return on assets (ROA), Return on equity (ROE) and Gross pro fit margin
(GPM) developed by Musiegaeth.al (2013) and Khan (2012). Data was analyzed by using
Descriptive analysis, Correlation coefficient method and Regression analysis.
Description
Keywords
Entrepreneurship and management, Management, Financial Management, Human Resource Management, Stock Market