Effects of Capital Structure in Pakistani Banks

Abstract

This study has been conducted to see the relationship between Capital Structure and Profitability of Pakistani Banks. All these banks are regulated by statutory body of State Bank of Pakistan. Sample data has been collected for 15 banks and 5 years data (2003-2007) has been used for analysis. Capital structure has been proxied by Gearing Ratio and performance has been measured by ROE and ROA which are dependant variables. Common Effect model has been used for investigating the relationship between capital structure and profitability. Result of this analysis shows that Gearing has negative effect on both ROA and ROE. Further the results suggest that banks should avoid high proportion of long term debt in their capital structure as it negatively affects their profitability margins.

Introduction

Main purpose of financial decision making is to “increase the value of shareholder’s of firm” and these financial decisions can be very tricky sometimes. One basic question “proportion of debt to equity?” and there could be hundreds of options but to decide which option is best in firm’s particular circumstances. Use of more proportion of Debt in capital structure can be effective as it is less costly then equity but it also has some limitations. After the certain limit it will affect company’s leverage (traditional theory of Capital Structure). Financially troubled or risky companies could face severe consequences as they normally have higher interest rates on debt. So there should be a balanced proportion of securities mix in firm’s capital structure. Capital structure affects leverage and consequently profitability of firm. Firms with less earnings and high leverage are more exposed to risk and less attractive for investors. “Effect of Capital Structure on the Profitability” is an effort to analyze, “Impact of capital structure on profitability of Banks in Pakistan”. For this research paper I selected 15 banks and their 5 years financial data i.e. 2003-2007.

Idea for this paper is taken from a research article written by Joshua Abor (2005). The variables used by Prof. Abor in that study are different from those I used for my paper. Gearing ratio is taken as an Independent Variable and dependent variables are Return on Equity (ROE) and Return on Assets (ROA). For better analytical results, Size (log of Total Assets) is kept constant and used as control variable.

This paper has been organized in a way that after introduction there is a brief literature review. Then literature review is followed by definitions of Capital Structure, its components, profitability and ratios. Next is methodology, sample banks and then regression analysis of data. This all followed by regression analysis and finding of this paper.

This has been conducted at Bachelors Level and it has certain unavoidable limitations. It is helpful for further studies in a way that now one doesn’t need to find the profitability of banks in Pakistan. And students can focus on certain broad areas like profitability interrelationship for local and multinational banks and so on.

Literature Review

Nicos Michealas, Francis Chittenden and Panikkos Poutziouris (1998) consider diverse non-financial and behavioral factors which influence capital structure decisions. They used exploratory method of conducting interviews for their study. They found that there are some factors like need for control, experience, mind perception and social norms etc made certain belief about debt and this belief make their attitude toward using of debt proportion in their capital structure. There are also large numbers of small firm owners who prefer to rely on internal generated funds rather than raising external finance.

John C. Groth and Ronald C. Anderson (1997) defined capital structure and examined its influence on the cost of capital and the value of a company. There is no equation exist to determine the optimal capital structure for firm. Proper use of debt and equity in capital structure lowers the weighted cost of capital and that low weighted cost of capital helps in increasing the value of the firm.

Arun upneja and Michael C. Dalbor (2001) examined the capital structure decisions of restaurant firms in USA. Pecking-order theory and position of the firm in the financial growth cycle are the bases for their study. Their result showed that both pecking-order and financial growth cycle influence capital structure decision of the restaurant firms. They found some separate factors which influence long term and short term debt decisions of the restaurant firms

Mohammed Amidu investigates dynamics involved in the determination of capital structure of banks in Ghana. The variables that are covered in this research article are profitability, growth, tax, asset structure, risk and size. This study highlighted the links between long and short forms of debt while making capital structure decisions. It is found that long-term debt structure is positively and statistically related to operating assets. While short-term debt and leverage move in same direction. The study suggests that profitability, corporate tax, growth, asset structure and bank size are important variables to influence banks’ capital structure.

Rajeswararao Chaganti and Fariborz Damanpour (Oct., 1991) tried to answer two main questions. One what are the relationships between outside institutional shareholdings, on the one hand, and a firm’s capital structure and performance? And secondly does the size of stockholdings by corporate executives, family owners, and insider-institutions modify those relationships? They have collected data from 40 pairs of manufacturing firms and found that the size of outside institutional stockholdings has a significant effect on the firm’s capital structure and family and inside institutional owners’ shareholdings moderate the relationship between outside institutional shareholdings and capital structure.

Mohamad Khan Bin Raji Jamal (1994) examined the influence of capital structure, particularly in the presence of market imperfections on firm’s profitability. The effect of corporate taxes, interest expense, debt level and equity size was also analyzed by him. The findings of this research paper are that higher debt level results in a lower profitability and higher profitability associates positively with taxation expense but negatively with interest expense.

F. Voulgaris, D. Asteriou and G. Giomirgianakis investigate the determinants of capital structure of Large Size Enterprises (LSEs) in the Greek manufacturing sector. The findings show that asset utilization, gross and net profitability and total assets growth have a significant effect on the capital structure of LSEs. Greek LSEs will face higher debt levels in the future that will arise mainly from higher short-term debt ratios. The ratios such as asset profitability, asset structure, return on equity, inventory turnover and liquidity which came out as significant determinants of capital structure in other empirical studies did not prove to be significant in this study.

Guorong Jiang, Nancy Tang, Eve Law and Angela Sze have tried to answer the question of “whether both bank-specific as well as macroeconomic factors are important determinants in the profitability of banks” and “A profitable banking sector is better to resist against negative shocks and contribute to the stability of the financial system or not”. They conclusion of their study is that a profitable banking sector can better resist against negative shocks and can help in stable financial system. In terms of bank-specific factors, operational efficiency is the most important factor in explaining differences in profitability and macroeconomic developments have also an important effect on bank’s profitability.

Chiang Yat Hung, Chan Ping Chuen Albert, Hui Chi Man Eddie (2002) shows the inter-relationship between profitability, cost of capital and capital structure among property developers and contractors in Hong Kong. The data for this research paper was collected from Datastream, an electronic financial database. The analysis of this paper shows that gearing is generally higher among contractors than developers and capital gearing is positively related with asset but negatively with profit margins.

Panayiotis P. Athanasoglou, Sophocles N. Brissimis, Matthaios D. Delis (2005) found the determinants of profitability in banking sector. According to their study size of the bank, financial strength, ownership status, operating expanse, cost decisions of bank’s management are the major factors influencing the profitability of Banks

Capital Structure

Capital Structure is defined as “the proportion of Debt and Equity used by the firm to finance its assets”.

Components of Capital Structure:

Capital Structure mainly comprises of Debt financing and Equity financing.

Debt Financing

Debt financing means borrowing money to run the business. The amount of debt that a firm uses to finance its assets is also called leverage. Debt Financing constitutes of Long term debt and Short term Debt based on the type of money one borrows. Interest rates for long term debt and short term are different and vary from situation to situation and firm to firm.

Long Term Debt

Long term debt means the money one borrows for financing the assets which can be used by the firm for longer periods. e.g.; Purchase of Assets, machinery, land etc. Long term debt is commonly called Long term loans or long term liability of the firm. The scheduled payment of long term loan is usually extended for more then 1 year. In the case of Banks their Sub-Ordinated Loans are Long term in nature because they are mostly for more then 1years depending on the nature on loan.

Short Term Debt

Short term debt is the money that is used for daily basis business operations like purchasing of inventory or paying the wages. Short term financing is referred to operating loan or short term loan and its scheduled payment takes place within the year. Usually short term loan is taken for some days or 3-6 months. Banks usually take loan from other financial institutions for very short period just to fulfill their daily requirement.

Equity Financing

Equity financing is composed of funds that are raised by the business itself. This financing can be raised by the owners of the firm or by adding more peoples in the ownership i.e. issuing the shares of the company. There is certain amount paid against these share and the shareholders get dividend against those shares or against that money they have invested in the company. It depends on the company’s policy that how much capital they need and how much capital should be raised through shares. Mostly those companies use equity financing which have high growth rate because they can give high return to the investors and can be attractive for the investors.

Measuring Profitability

Company’s main objective is to maximize shareholder’s wealth. This can only be possible when company will earn profit and this can be done by using company’s assets properly.

Investor’s main concern is about how much company is earning because his money is invested in company. There are some methods used to measure profitability and one of them is Profitability Ratio Analysis.

Investors make their decisions of investing in a company by calculating profitability ratios of that company. These ratios are the financial statement ratios which focus on how well a business is performing in terms of profit and how profit is earned relative to sales, total assets and net income. Main ratios used for the analysis of profitability are Profit Margin ratios, Return on Assets (ROA), Return on Equity (ROE) and Return on Invested Capital (ROIC). Ratios used in this research paper are ROE, ROA and Gearing ratio.

Methodology

I have selected 15 banks for this analysis. These banks are given under the heading of Sample Banks. Their 5 years data is analyzed through different ratios (Annexure 1).

Sample Bank

Allied Bank Limited

Askari Bank Limited

Bank Al-Falah Ltd

Bank Al-Habib Ltd

DUBAI ISLAMIC BANK

Habib Bank Limited

HABIB Metropolitan Bank Ltd.

MCB Bank Limited

Meezan Bank Ltd.

MY Bank Ltd.

National Bank of Pakistan

Pak Kuwait Investment Company (Pvt) Ltd

Saudi-Pak Commercial Bank Ltd

United Bank Limited

Zarai Taraqiati Bank Limited

Variables

These are the values that change in relation to each other. There are dependant variable and independent variables. There is also control variable used in this research process.

Dependent variable

Dependent variables are those that are observed to change in response to the independent variables.

For example, market price of stock is a dependent variable influenced by various independent variables, such as earnings per share, debt-equity ratio, and beta.

There are two dependant variables used in this research paper.

Return on Equity (ROE)

This ratio is used to measure how much the company is earning with the money of shareholders. A business having a high return on equity is considered to be more attracted for the shareholders because it is using shareholders money in effective way to make profit.

ROE= Net Income/ Shareholders Equity

Return on Assets (ROA)

ROA ratio is used to analyze how much company is profitable in terms of its assets. This ratio gives us an idea of how well a company is using its assets to generate profit. It is also called as Return on Investment (ROI). The higher the ROA value better the profitability of firm, because the firm is earning more money on less investment and is good in converting its investment into profit.

ROA = Net Income/ Total Assets

Independent variable

An independent variable is that which is supposed to affect or determine a dependent variable. Gearing is used as an independent variable in this research paper.

Gearing ratio is measure of financial leverage. This is a type of financial ratio that compares the degree of firm’s activities funded by borrowings with amount of money funded by shareholders.

If financial leverage is high then company is considered to be more risky. Some of gearing ratios includes debt-to-equity ratio (total debt / total equity), times interest earned (EBIT / total interest), equity ratio (equity / assets), and debt ratio (total debt / total assets).

In this analysis gearing ratio used is,

Gearing ratio = Long Term Liabilities/ Shareholder’s Equity

Control variable

These are the variables that are not supposed to change throughout the research process. Control variables are irrelevant factors that possibly affect experiment but are kept constant to minimize their effects on outcome.

In this research paper Size is taken as control variable.

Size is Log of Total Assets i.e. ln( total assets)

Data Analysis

Panel data

Panel data refers to two-dimension data. A data set containing observations on multiple phenomena observed over multiple time periods is called panel data. A panel dataset should have data on i cases, over t time periods, for a total of i × t observations.

Panel data analysis has three independent approaches.

Independently pooled panels;

Random effects models;

Fixed effects models or first differenced models.

Common Effect Model

A common effect model looks like yit = a + bxit + εit, where y is the dependent variable, x is independent variable, a and b are coefficients, i and t are indices for cases and time. I used Common Effect Model for analysis in this paper. Equations used in this model are

ROE it = α 0 + β1 Gearing it + β2 Size it + ε it

ROA it = α 0 + β1 Gearing it + β2 Size it + ε it

ROE = Net Income divided by S. Holder’s Equity for i cases in t time.

Gearing = Long term Liabilities divided by S. Holder’s Equity for i cases in t time.

Size = Log of Total Assets for i cases in t time

ROA= Net Income divided by Total Assets for i cases in t time

Results

Dependent Variable on ROE

Table 1

Description

Coefficient

T-Statistics

P-Value

Intercept

-1.5552

-2.3576

0.0211

Gearing

-0.0218

-3.1969

0.0021

Size

0.1033

2.8395

0.0058

Table 2

R Square

0.16443

Adjusted R Square

0.14121

F-Statistics

7.08411

Significance F

0.00155

Dependent Variable on ROA

Table 3

Description

Coefficient

T-Statistics

P-Value

Intercept

0.0472

1.1052

0.2728

Gearing

-0.0017

-3.8030

0.0002

Size

-0.0008

-0.3548

0.7238

Table 4

R Square

0.18955

Adjusted R Square

0.16704

F-Statistics

8.41995

Significance F

0.00052

Both tables 1 and 3 show that gearing is negatively affecting Return on Equity and Return on Assets as their coefficient is showing negative value. In Table 1 T-Stat value is 3.196 regardless of sign which shows that result is significance because value is more than 1.96. P-Value is also showing the same significance as its value is less than 5% (.05). In table 2 the value of Adjusted R Square and R-Square is less which does not mean that number of explained variables are lesser or model does not fit well but it is because of panel data. In Table 3 T-Statistic value of 3.80 is also showing the significance of result. This result reveals that Banks using high proportion of debt in their capital structure have low Return on Equity and Return on Assets which is negatively affecting their profitability.

Conclusion

Capital is raw material for a firm. A firm takes financial Capital and converts it into its assets and these assets are operated to earn profits (John C. Groth and Ronal C. Anderson). One basic question “proportion of debt to equity?” and there could be hundreds of options. There is no equation exist to determine the optimal Capital Structure of a firm. In Pakistan different banks have different proportion of debt and equity for financing their capital. This study evaluated the relationship between capital structure and profitability and it revealed that banks which are using high proportion of long term debt in their capital structure are less profitable and vice versa. Their long term liabilities are negatively affecting their profitability. As we can see from the results that gearing has negative relationship with return on assets and return on equity. So it suggests that banks should use less amount of long term debt in their capital structure and keep their long term liabilities under control. If they use high proportion of long term debt then they should use positive security against their long term liabilities.

There are some other factors found which also affect the banks profitability which are not focused in this study. One of the main factors is the regulations and restrictions from the State Bank of Pakistan. Some other factors are size of the bank, financial strength (tier I capital and tier II capital), ownership status, operating expanse, cost decisions of bank’s management, privatizations of Banks and composition of Bank’s assets and liabilities.