The Impact of Capital Structure on Firms' Profitability: A Comparative Analysis of Textile Firms and Commercial Banks

Abstract

The purpose of this study is to explore the relationship between capital structure and firm profitability from an index perspective of the Pakistan Stock Exchange (KSE-100). The objective of this study is to provide insight into how profitability varies across sectors. This study examines the two most prominent sectors in the economy: textiles (a capital intensive manufacturing sector) and banking (a highly leveraged service sector). As prior research regarding the KSE-100 index has often failed to take into account sectoral differences, this study utilizes a comparative approach in order to examine the time frame of 2019-2023. A panel dataset of forty firms was created for this study: twenty firms in the textiles sector and twenty firms in the banking sector. A quantitative methodology was utilized to collect data on capital structure (defined as the Debt-to-Assets ratio [D/A]) and profitability (defined as the Return on Assets [ROA]). Data for this study came from company reports, PSX records and State Bank publications. To analyze the data, descriptive statistics, augmented Dickey Fuller unit root tests, Pearson correlation coefficients and pooled ordinary least squares (OLS) regression were used. Results indicated a statistically significant positive relationship between leverage and profitability in both sectors. In the textile sector, the coefficient for the D/A ratio was 0.1116 (p < .05) which implies that as leverage increases, so does the ROA. Potential explanations for this finding may be the use of debt efficiently or tax benefits. Similarly, in the banking sector, the coefficient for the D/A ratio was 0.1063 (p < .05) which suggests that in addition to generating revenue via debt, the banking sector's reliance on debt is also a major determinant of their profitability. However, it should be noted that the R-squared values for both sectors are negative (-0.277 for textiles and -3.014 for banking) which indicates that leverage is responsible for very little of the variance in profitability in either of the sectors. Further, Pearson correlation coefficients for both sectors were low (.038 for textiles and .072 for banking) which lends additional credibility to the notion that numerous other sector specific and macro economic factors (e.g. operating efficiency, cost control, revenue diversification, etc.) have much greater influence over profitability than does leverage. The results of this study support the trade off theory which states that if used properly, debt can lead to higher returns; but the results also emphasize the need for firms to develop sector specific strategies. Recommendations for corporate managers and policymakers based on the findings of this study include to exercise caution when managing leverage, to utilize multiple ways of driving profitability and to create policies that maximize the financial options available to firms. This study provides updated and sector-specific information to corporate managers, regulatory agencies and researchers.