IMPACT OF FINANCIAL

LEVERAGE ON CEMENT
SECTOR INDUSTRY IN
PAKISTAN
INAM-UL-HAQUE

16
Introduction:

Finance is one of the most important erection blocks of modern society that
encourage economies to make progress. Without finance and debt, countries and
firms cannot progress very much and stay pitiable. When they can grow and save,
individual consumers can consume even without current income. Finance is also
considered to be the core area of any business organization and must be dealt with
a lot of care and concern.

Financial leverage can be defined as the extent to which a business or an investor is

using the borrowed money. Financial leverage is a measure of how much a firm is
using equity and debt to finance its assets. As debt increases, financial leverage
increases. It is often said that a relationship exists between the financial leverage
and the performance of the companies.

One of the most important reference theories in enterprises financing policy is the
theory of capital structure theory and different studies use capital structure theory
to draw attention to the importance, impact and significance of debt financing.
Capital structure of a firm is defined by its leverage; which is a blend of borrowed
money (debt) and equity. The most important and crucial issue that managers are
facing today is how to choose the Ratio of debt and equity to achieve optimum
capital structure that would minimize the firm’s cost of capital and improves return
to the business. According to some previous studies, financial leverage affects cost
of capital, ultimately influencing firms’ profitability and stock prices (Higgins,
1977; Miller, 1977; Myers, 1984)

Another theory which is named as trade-off theory, describes that a firm selects
how much debt finance and equity finance, a firm needs to utilize by comparing

Impact of Financial Leverage on Cement Sector Industry INAM-UL-HAQUE

and evaluating the costs and benefits of each type of finance. Certainly such
preference is not contemporary it is rather familiar to researchers and managers
(Butters 1949). In this theory, the management of the firm must evaluate the
different types of costs and benefits of the optional leverage strategy and must aim
at a level of debt to value, which is depending on establishing a balance between
debt tax shields and costs of bankruptcy (Myers (1984)).

Leverage is a term which refers to the extent to which firms make use of their
borrowed money to increase profitability and is measured by total liabilities to
equity. Firms that borrow large and heavy amounts of money during a business
recession are more likely to be unable to pay off their debts as they come due; they
will end up with high leverage and are more likely to end up with a potential risk
of bankruptcy. On the other hand, the lower the firm's borrowings, the lower the
leverage, and the risk of bankruptcy will in the long run be lower which signifies
that business will continue operating.

Profitable firms can issue debt at low rates of interest since they are seen as less
risky by the creditors; in addition, profitable firms are able to make large profits
and use a less amount of debt capital than firms that make little profit (Titman and
Wessel, 1988; Mazur, 2007; Rajan and Zingales, 1995; Abor, 2005). Moreover,
profitable companies are tending to decrease information unevenness to investors,
creditors and potential and interested users through the profitability (Myers, 1984;
Liaqat. A.2011). Therefore, there is a relationship between leverage and
profitability (John and Williams, 1985; Liaqat. A., 2011; Tong and Green, 2005;
Al-Najjar and Taylor, 2008; Mazur, 2007)

Bos and Fetherston, (1993), conducted a study and proposed that, capital structure
affects the performance and profitability and riskiness of firms. This has been
proved by early researchers such as Miller and Modigliani (1963) and Titman and

Impact of Financial Leverage on Cement Sector Industry INAM-UL-HAQUE

Wessel (1988). Yoon and jang (2005) described the relationship between return on
equity, financial leverage and firm size in the restaurant industry. His research
found that during the test period firm size had a more leading effect on Return on
Equity of restaurant firms than debt use; larger firms are earning much higher
equity returns.

Abor (2005) in his study in Ghana has reported that there is a significant positive
relationship between short-term debt to total assets and profitability ratios but there
is a negative link between long term debt to total assets and profitability ratio.
Senior et al (2013) have studied the relationship of leverage and firm performance.
The results drawn during the study suggested that leverage was very significant in
influencing returns on equity, return on assets and the operating profit of listed
banks in Ghana.

The aim of this study is to investigate the effect of financial leverage on cement
manufacturing industries’ profitability that is registered on Karachi Stock
Exchange. To find out the result one independent variable, financial leverage is
used in least square method of simple regression model which is calculated as the
ratio of total debt, which includes short term and long term debts, to total assets
which include current assets and noncurrent assets. Dependent variable is
profitability which is measured by the ratio of net income after tax to total assets
(ROA).

Literature Review:

A lot of research has already been conducted on the impact of financial leverage on
firm profitability. Titman & Wassels (1988) in his study explained that the firms
which use their earnings or profits can earn more profit than those which rely on
debt financing. The share price of firm is true depiction of its performance. If share
price of the firm is higher than firms prefer to issue equity instead of taking debt

Impact of Financial Leverage on Cement Sector Industry INAM-UL-HAQUE

capital that helps them to maintain their leverage. Wald (1999) in his research
study argued that debt to assets ratio has significant negative relationship with the
firm profitability. He did his study on the firm’s capital structure which operates in
United State, United Kingdom, Japan, France, and Germany. He used firm size,
growth and firm’s riskiness as explanatory variables.

Covan (2011) have conducted a research and described the relationship between
equity financing and cyclical behavior of debt. He found that during a recession, a
reduction in economic conditions, there has been a limited use of external capital
and firms prefer to rely on equity financing. Akbarian (2013) studied the effect of
financial leverage and environment risk on firm performance of listed companies
on Tehran stock exchange. The result proved that there is a negative relationship
between financial leverage and cash flow per share and between other variables
which are market risk and economic risk with free cash flow per share positively
significant. It also suggested that financial leverage, market risk and economic risk
with return of equity have positive significant relationship.

Sheel (1994) in his study also supported the negative relation between debt to
assets ratio and profitability of firms. Cross sectional regression analysis was used
to study the leverage behavior of 32 firms in two industry groups, Hotel industry
and manufacturing industry. The results confirmed that all leverage determinants
except firm size are significant in describing the changes in leverage and debt
behavior. Eunju & Soocheong (2005) studied the relationship between
profitability, financial leverage and size of the firm in restaurant industry. He used
ordinary least square method in his study. The aim of this study was to find out the
relationship between financial leverage and restaurants firm profitability and risk.
To achieve this objective of study, he made three hypotheses. The first hypothesis
was restaurant firms using a low level of financial leverage have more profitable. If
a restaurant firm has a higher level of financial leverage then it has to pay a

Impact of Financial Leverage on Cement Sector Industry INAM-UL-HAQUE

significant amount as interest expense. Second hypothesis was; firms which use a
higher level of financial leverage are more risky than those with a lower level of
financial leverage. In his study he calculated return on equity as a measure of
profitability and financial leverage as a ratio of long term debt to total assets and
total assets as firm size. The results concluded that the restaurant firms who have
large assets were more profitable than small firms and there was a negative
association between financial leverage and firm profitability.

Larry & Stulz (1995) conducted a study to check the impact of debt financing on
firms profitability in Ghana and he concluded that there is positive significant
association between total debt and total assets and return on equity. An earlier
study of Murphy (1968), on financing behavior of listed Chinese firms suggested
that a negative relationship between profitability and firm’s financial leverage
exists. A higher rate of return on equity capital should earn more profits and
dividends and increase in the value of common stock. The return on equity capital,
earnings and dividends and market value of the firm’s common stock are all
directly related to the leverage. The long term debt to total capital ratio was seen to
be unrelated to a firm’s price to earnings ratio and to dividend yield on its common
stock in all industries. Gupta (1969) in his study suggested that debt is considered
to be a way to emphasize investors trust in the company, if a company uses debt it
gives a signal to the markets that the firm is expecting to generate positive cash
flows in the future. The principal and interest payments on debt are fixed liabilities
which the firm has to pay out of its cash flows despite of economic conditions and
firms profitability.

Amsaveni (2009) conducted a study and concluded that there is a negative

relationship between leverage and future growth of firms. This relation is negative
for those firms whose growth opportunities are not recognized by the capital
markets or are not available to overcome the effects of their debt sufficiently. To

Impact of Financial Leverage on Cement Sector Industry INAM-UL-HAQUE

examine the relationship between leverage and growth they used a data of a period
of more than 20 years and concluded a strong negative relationship between them.

Mangalam & Govindasamy (2010) have also researched to analyze and describe
the effect of financial leverage on the profitability of the firm. For this purpose,
they investigated the relationship between the leverage and the earning per share.
They made an analysis on leverage in three ways which were financial leverage,
operating leverage and combine leverage. For the purpose of analysis, they
selected a sample data of seven public limited companies listed on the Bombay
stock exchange. These were ACC Cement, Chettinad Cement, India Cements,
Dalmia Cement, Ambuja Cement, Birla Cement and Prism Cement. A period of
seven years was taken for analysis. He used Analysis of Variance (ANOVA)
method in his study. He made the hypothesis to test the relationship between
degree of financial leverage and earnings per share. Operating leverage is caused
by fixed operating expenses of a firm. It is the ability and responsibility of the firm
to use fixed operating costs to test the effects of changes in sales and on its
earnings before interest and taxes. Financial leverage is related directly with the
fixed financial costs in firm. It is the firm’s ability to use fixed financial charges to
highlight the impact of change in earnings before interest and tax and on the
earning per share. It is also related to the funds borrowed to finance the activities
of the firm to increase the profitability and share holder’s wealth. The financial
leverage or debt capital employed by the firm is estimated to generate more return
than their costs. There is a close relation exists between the financial leverage and
earnings per share of the company. If ratio of financial leverage is high and the
return on investment is greater than the cost of debt capital, then the affect of
financial leverage on Earning per Share will be favorable. The impact of financial
leverage is adverse when the earning capacity of the firm is lower than the
expectation by the lender. It was suggested that there is a significant negative
relationship between financial leverage and earnings per share. The leverage effect

Impact of Financial Leverage on Cement Sector Industry INAM-UL-HAQUE

is positive when the earnings of the firm are higher than the fixed cost to be paid
for the lenders. The leverage is an important factor which is directly related to the
profitability of the firm and shareholders wealth can be maximized when the firm
is able to employ more debt.

Baker (1973) studied the effect of financial leverage or greater use of debt capital,
on profitability of firms. This study is based on a model consisting of two
equations, the first one is explaining industry profitability in terms of the normal
market structure variables plus leverage and the other one was a new equation
related to risk variables to explain leverage. He measured inversely as the ratio of
equity to total assets for the leading firms of the industry and took a data of over a
period of ten years. First he used ordinary least square method of estimation which
showed that leverage is significantly related and has negative sign which shows
that low amounts of leverage tend to increase industry profit.

Dalber and Upneja (2002) used a pooled regression analysis and described theories
related to debt maturity and debt selection (contracting costs of debt, signaling
effects, and tax effects). Firms that have growth opportunities should need less
long-term borrowings because they are able to make more investments and they
are not willing to pay a high fixed costs in respect of interest payments. Long-term
debt signals wrongly about a firm’s market value; the market value of its common
stock. As for as tax effects are concerned, a firm which is paying a higher tax rate
prefer to use more long-term and more risky debt.

Pinegar and Wilbricht (1989) conducted a survey of 500 firms, only 31 % of the
firms appear to use target capital structure. Hittle, Haddad, and Gitman (1992)
surveyed the 500 largest Over-The-Counter firms and found that only 11 % of the
firms use target capital structure. Moreover, when both taxes affect was considered
at the same time between corporate and equity holders, it was found that financial

Impact of Financial Leverage on Cement Sector Industry INAM-UL-HAQUE

leverage does not appear to bring significant benefits to the investors (Myers,
2001). Even if this is very difficult to study and describe the agency cost/tax shield
trade-off theory, Sunder and Myers (1999) suggested that the most profitable firms
in many industries are often seen to use the lower debt ratio, which is quite
different from the expectations using the trade-off theory. Dann (1981) and James
(1987) also suggested that there is a positive relationship between the returns for a
firm’s stockholders and financial leverage. In contrast to the trade-off theory, the
pecking order theory of capital structure describes that firms normally have a
preferred structure for financing decisions. The highest preference is given to use
internal financing such as retained earnings. If a firm uses borrowed money or
external funding, the preference is given to debt, convertible securities, preferred
stock, and common stocks of shareholders (Myers, 1984). This structure shows the
motivation of a financial manager to lower and minimize the agency costs of
equity (Hawawini & Viallet, 1999). However, it is said that the pecking order
theory also has its limitations. It does not explain the impact and affect of taxes,
financial misery, issuance of security costs, or the investment opportunities
available to a firm in that firm’s actual capital structure. In reality and practical
situations, it is quite impossible to find out the real situations with one or two
theories.

Impact of Financial Leverage on Cement Sector Industry INAM-UL-HAQUE

Theoretical Framework:

The aim of the study is to find out the impact of financial leverage on profitability
and financial performance of cement manufacturing firms listed on Karachi Stock
Exchange. For this purpose the following variables were assumed to be more
important.

 Dependent Variable

The dependent variable which is used in this research study is the financial
performance (Profitability) of the listed cement manufacturing companies at
Karachi Stock Exchange. The financial performance will be measured by using
this indicators which are, Return on Assets (%), Return on Equity (%).

 Independent Variable

Financial leverage is used as an independent variable in this study, which is

measured by using debt to equity ratio. The relationship between dependent and
independent variable can be explained by the following equation:

Financial
Leverage

Return Return
on Equity on
Assets

Impact of Financial Leverage on Cement Sector Industry INAM-UL-HAQUE

Financial Leverage is considered as the existence of debt in a firm’s capital
structure of a firm and debt–total assets ratio is an acceptable measure of financial
leverage. Financial Performance is a general measure of a firm's overall financial
health over a given period of time.

It has been proved form previous researches that there is a negative relationship
between profitability and financial leverage. When a certain company relies
heavily on debt financing rather than equity financing, it produces less profit
because a part of profit is given interest on debt financing. Dr. Khalaf Taani (2012)
study indicated that the firm’s working capital management policy, financial
leverage and size have significant relationship to the net income, ROE, and ROA.
Pratheepkanth (2011) concluded that there is a positive but weak relationship
between gross profit and capital structure of the firm, there is a negative
relationship between net profit and capital structure. It shows the high financial
cost of the firm. ROI and ROA also have negative relationship with capital
structure.

METHODOLOGY

Method of Data Collection:

The data required to perform the research was secondary data which was gathered
from the official web sites of cement manufacturing companies operating in
Pakistan and listed on Karachi Stock Exchange. Audited Financial statements of
five firms were used to perform the research.

Sample Size:

There were seventeen cement manufacturing companies listed on KSE 100 index,
five companies were selected, while remaining companies were excluded because
the data was not available of these listed companies for the sample year. The data

Impact of Financial Leverage on Cement Sector Industry INAM-UL-HAQUE

selected for the purpose of research consisted of five years annual data of the
variables used in this study. Data of all these variables belongs to period starting
from year 2011 to year 2015.

Variables Details:

Financial performance (Profitability) is used as dependent variable in this study.

Profitability is a comprehensive indicator of a firm’s financial performance
because it provides information as to how well company is using its assets to
generate profits to increase shareholders wealth.

Financial Performance/Profitability Ratio:

ROA = Net Income / Total Assets

ROE=Net Income/Shareholder’s Equity

Financial leverage is used as independent variable in this study which was

measured as the ratio of total debt to total assets. Total debt includes short-term
debt having maturity life of less than one year and long term debt having maturity
life of more than one year. This ratio gives an indication of a company’s total
liabilities in relation to their total assets. The higher the ratio, the more leverage the
company is using and the more risk it is assuming.

Financial Leverage = Total Debt / Total Assets

Statistical Technique:

Simple Linear Regression analysis was used to test the hypothesis. This technique
was used in this study because the dependent and independent variables are
numerical data and under this situation the prediction power of regression analysis
is stronger as compared to other available techniques.

Impact of Financial Leverage on Cement Sector Industry INAM-UL-HAQUE

Results:

To identify the relationship between financial leverage and profitability well

known statistical method is used in Statistical Package for the Social Sciences
(SPSS) .

Model R R. Square Adjusted R.Sq Std.E. Reg

1 0.6202 0.3844 0.3707 5.396252

The above mentioned table shows 38% variability in dependent variable due to
change in independent variable that is financial leverage and the rest of the change
is due to any other factors.

ANOVA test is also used to test the significant relationship between the above
mentioned variables. The table given below will help us to understand the
relationship.

Model Sum of Sq. df Mean Sq F Sig

Reg. 3252.73 1 3252.73 47.32 0.000
Res. 8604.61 106 76.081
Total 11857.34 107

Coefficients:

Model 2 B S.E B t Sig.

Constant 24.002 3.173 --- 7.564 0.000
Fin.Lev -.348 0.052 -0.56 -6.710 .000

The negative values denote the negative relationship between profitability and
financial leverage as shown in the table. If there is a positive relationship between
these variables, the results would have been positive.

Impact of Financial Leverage on Cement Sector Industry INAM-UL-HAQUE

Conclusions:

Hence we can conclude that there is a significant negative relationship between

financial leverage and profitability of Cement manufacturing Industries of
Pakistan. The same results were also produced by different other studies conducted
at different time periods. Furthermore uncertain political conditions and energy
crisis are also affecting the sector to some extent.

Impact of Financial Leverage on Cement Sector Industry INAM-UL-HAQUE

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Impact of Financial Leverage on Cement Sector Industry INAM-UL-HAQUE