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Empirical use of Corporate Capital Structure and Financial Leverage

Introduction

Australia is connected to the global economy using shipping and the movement of air, which transport the commodities. The Australian freight market is estimated to grow by 2.5% from 2020 to 2024(Australian Bureau of Statistics, 2020). The markets are segmented by freight forwarding, freight transportation modes, value-added services, and warehousing. A practical, sustainable, and cost-effective freight industry has been enabled using partnership through every government level, which supports the growing economy of Australia and quality of life (Yazdanfar, 2012). The government has also played a significant role in the long-term planning and management of transport networks. The growing freight industry of Australia is also facing infrastructural challenges wherein billions of dollars have been invested by the government to attain an effective supply chain process. In the research of business, the main objective of the study is to acknowledge the factors that affect negatively or positively the profitability of the firms. Financial leverage and capital structure are the topmost factors that affect the firms (Qiu and Bo, 2010). It possesses the concept of capital structure management. It is stated that since the firm's value depends upon the profitability and investment risks, it is, however, independent of the capital structure. The freight transport industry is believed to be highly competitive due to minimal entry barriers and many participants because of a lack of economies of scale. Thus, by acknowledging the issues, one can recognize the problems and analyses the value of financial leverage and capital structures.

Significance of the study

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The purpose of the study is too critical to understand the corporate capital structure and financial leverage to enhance the profitability of firms in the Australian freight industry. This research will help determine the practical application of economic power and capital structure to improve financial performance. This study helps in acknowledging the financial decisions of debt and even underline profitability and investment risks. This study is also significant as it helps in improving the conflicts that take place between stakeholders and also convert information to the capital markets regarding the mitigating effects of the adverse selections (Kochhar, 1997). This study will also highlight the influence of products in the product market and the results of disputes upon corporate control. This study will also concentrate on analyzing strategies to uplift the performance and profitability of the Australian freight industry.

Problem statement

After acknowledging the freight industry's present situation in Australia, it has been believed that various plans and strategies have been adopted by the Australian councils to improve the overall performance of the freight industry. Financial leverage and capital; structures vary greatly both by sector and by business sectors (Li and Stathis, 2017). There are various industry sectors, such as the freight industry, wherein companies operate through a higher degree of financial leverages. In addition to that, the excessive usage of economic power leads to a decline in the firms' performance and results in a significant loss. In addition to that, although capital absorbs losses and costs and even enhances growth using mergers, acquisitions, and takeovers. However, the ineffective structure of money further leads to effects on the organizing of transactions and also reduce the strategic assets. It is found that shareholders run the company, which maximize the values of shareholders, wherein managers manage to attain benefits and incentives (Musah and Yusheng, 2019). This brings conflicts of interest between shareholders and managers and further leads to agency costs and also expenses. The study aims to analyse the practical usage of corporate capital structure and financial leverage to enhance its profitability in the Australian freight industry. The objective of the study is as follows:

  • To review challenges faced by the Australian freight industry
  • To analyze the role of corporate capital structure in enhancing the profitability of firms in the Australian freight industry
  • To acknowledge the application of financial leverage to uplift the Australian freight industry’s profit

Literature Review

Profitability

The ultimate goal of every business organization operating in different sectors and industries is to become profitable and earn maximum profit from their operations. However, the choice of measure of profitability tends to vary and depends on the choice of ratios and formulas. Notably, there are several measures of profitability that are used to measure profitability. Accordingly, the extent of profitability that the proposed research will use will be generated based on the measurement of profitability used in the previous research studies and literature. Accordingly, Chaklader & Chawla (2016) conducted an empirical study examining the capital structure's determinant. In this study, the authors have used ROE (Return of equity) as one of the independent variables. However, the authors have not mentioned the reason behind the use of ROE as the measure of profitability. In another study, Dalci (2018) investigated the impact of financial leverage on the profitability of the manufacturing firms and used ROE as the measure of profitability but included other actions such as ROA (Return on Asset). In a similar context, Le & Phan (2017) also measured the profitability, which they defined as the performance. However, the authors used ROE as well as ROA, along with Tobin’s Q as the measurement of profitability. Considering the previous research, it has been identified that ROA is a commonly used measure of profitability (Gill, Biger, Pai, & Bhutani 2009; Shah, 2012; Ahmed Sheikh & Wang, 2013; Le & Phan, 2017; Dalci, 2018). In this regard, Bettis (1981) argued that ROA provides an adequate measure to indicate the return, which is controlled by the company's management. At the same time, the author argued that ROA is the most widely used measure of profitability by the managers as well as other stakeholders and this measure of profitability is in many cases correlated with another widely used measure of profitability that is ROE. Likewise, Simerly & Li (2000) argued that ROA is key to profitability, while ROE is claimed to ignore the impact of certain types of resource investment. Also, high ROE often indicates a heavily leveraged company, while low ROE depicts the opposite. However, the authors have argued that both ROE and ROA serve as adequate measures to capture the firm’s contribution concerning public investment resources. Berk & DeMarzo (2013) argued that the critical strength of ROA is that this measure of profitability is less sensitive to leverage compared to ROE. However, it has been further contended that ROA is more sensitive to changes in the working capital in comparison to ROE. Correspondingly, it can be argued that there is no specific measure of profitability that can be considered superior to another. However, previous studies show that ROA is the most widely used measure of profitability. Hence, based on the last study research, the proposed study will involve using ROA as the measure of profitability.

Impact of Capital Structure on the Profitability

According to Singh & Bagga (2019), capital structure has always been a significant subject of interest and discussion among the researcher, academician, and corporate world. It has been noted that over the years, several studies have been conducted examining the relationship between the capital structure and the profitability of the firm. Accordingly, Chiang, Chan & Hui (2002) conducted an empirical study, which included a sample of 35 companies listed in the Hong Kong Stock Exchange. The findings suggested that capital structure and the profitability of the firm are interrelated. In another study, Abor (2005) studied the relationship between profitability and the capital structure, taking the companies from the Ghana Stock Exchange as the sample. In this study, it was found that there is a significant positive relationship between the short-term debt to total assets ratio and ROE. However, on the other hand, this study found that there is a negative relationship between the long-term debt to total assets ratio and ROE. In another study, Gill et al. (2011) investigated the impact of the capital structure on the profitability of the service companies in America. The findings from this study also demonstrated that there is a positive relationship between the short-term debt to total assets and ROE as well as between total debt to total assets and ROE. In another study In an empirical study, Salim & Yadav (2012) investigated the relationship between the capital structure and the profitability using panel data analysis of 237 listed companies in the Malaysia Stock Exchange from 1995 to 2011. In this study, they used equity, return on asset, Tobin’s Q, and earning per share as the measure of profitability, while they used long-term debt, short-term debt, and growth as the measure of capital structure. The empirical test conducted in this study demonstrated that there is a significant positive relationship between the capital structure and the performance of the firm. Arabahmadi & Arabahmadi (2013) examined the effect of the capital structure on the firm's profitability. They used data from 252 non-financial companies on the Tehran Stock Exchange from 1999 to 2008. Similar to the findings obtained from other researchers, Arabahmadi & Arabahmadi (2013) found a positive relationship between short-term debt and the return on equity. These findings suggest that short-term obligations with a low-interest rate are more likely to contribute to the firm's increased profitability. Still, in situations where the firm increases the long-term debt, it can lead to a decrease in profitability. Although the majority of the studies in the recent past identified that there is a positive relationship between the capital structure and the profitability of the firm, some studies have found that there is a negative relationship between the capital structure and the firm’s profitability. In this regard, in a survey conducted by Titman (1988), it was found that debt is negatively related to the firm's performance. Similar findings were also obtained in a study conducted by Rajan and Zingales (1995) in which it was found that profitability is negatively influenced by the debt. These results were supported by Omondi &Muturi (2013), who argued that capital structure has a significant negative impact on the financial performance of the firms. In a similar context, Bouraoui & Louri (2014), in a study, examine the effect of capital structure on profitability in which it has been stated that changes in the capital structure hurt the profitability of the firm. Apart from these studies, several Australian studies have been conducted examining the impact and relationship between the capital structure and its profitability. In this regard, Qiu & La (2010) conducted a study examining the relationship between firm characteristics and capital structure using a sample of 367 Australian companies for 15 years. Accordingly, this study finding illustrated the role of debt on profitability, which suggested that the profitability of the firm has the potential to reduce the debt levels of the firms in Australia. In another study, Barth, Richard, & Levine (2001) conducted empirical research examining the factors influencing the relationship between profitability and capital structure, taking companies from 107 countries, including Australia, as a sample for the study. Accordingly, this study found that the relationship between profitability and capital structure influenced other regulatory power factors, supervision. Based on the review of previous studies, the proposed research will use the debt to equity ratio and debt to total assets ratio as the measure of the capital structure (Nasimi & Nasimi, 2018). These two ratios are identified to be widely used as the measure of capital structure.

Impact of Financial Leverage on the profitability

According to Olang (2015), financial leverage refers to the composition of debt in the firm’s capital structure. As per Gill & Mathur (2011), economic power in the context of business generally refers to loans that the firm uses to finance its purchases. According to Asif, Rasool, & Kamal (2011), it has been argued that when the firm incurs a considerable number of debts or leverage, it increases the possibility of bankruptcy. Nonetheless, Jarrow (2013) argued that financial power also positively impacts certain aspects of business firms. In this regard, it has been argued that economic leverage can increase the firm’s return and generate more profit for the firm, particularly in return on the equity. Correspondingly, Bhatti et al. (2010) argued that taking debt is not only wrong, but it can also have a positive impact on firms seeking growth. However, it has been further argued that the time at which the debt is incurred is often a matter of significant concern for the investors. As per a study conducted by Ali (2011) with the USA firms, it has been suggested that the use of financial leverage by the firms can increase earnings per share. However, it has been acknowledged that incurring too much debt or financial leverage can lead to default risk. Over the years, many research studies have been conducted examining the relationship between financial leverage and profitability. In this regard, some research studies have concluded that economic power has a positive relationship with the firm's profitability. In contrast, other research studies have identified negative relationships between the two variables. According to Lartey, Antwi, & Boadi (2013), it has been argued that profit reacts when the leveraging rises, which signifies that there is a positive relationship between profitability and financial leverage. In another study, Asif, Rasool, & Kamal (2011) claimed that growth and earning from financial power is significant. Moreover, it has been stated that the use of financial leverage also positively influences the firm’s market value. In a similar context, Memon et al. (2012) also supported these findings and stated a positive relationship between profitability and financial leverage. In this regard, it has been argued when the firm incurs debt and its external finance increases; it maximizes the shareholder's wealth. Additionally, Kraus and Litzenberge (1973) also argued that when the firm has increased control over the business operations, then there is a positive relationship between the earning power of the firm and the financial leverage. However, some research studies have also argued that there is negative financial leverage that hurts the firm's profitability. In empirical research conducted by Dalci (2018), the finding suggested a U-shaped relationship between economic power and profitability and argued a positive relationship between the two variables. The positive relationship between these two variables is claimed to be related to several factors, such as increased tax advantage of debt and differences in the tax rates. Nonetheless, it has also been argued that financial leverage may not always have a positive effect on the profitability of the firm. In this regard, excess economic power is discussed to contribute to the decline in the profitability of the firm due to increasing financial distress as well as bankruptcy cost. The negative effect of the financial leverage on profitability is claimed to be associated with factors such as information asymmetry and agency problems within the firm between the managers and the shareholders. Moreover, it has been observed from the previous literature that there are different measures of financial leverage that have been implemented by the researchers. However, the proposed research study will involve the long term debt ratio and short term debt ratio as the measure of financial leverage in the study because it is the most commonly used measure for this variable (Dalci, 2018)

Conceptual Framework and Research Questions

Based on the review of literature presented above, the following conceptual framework has been framed. Accordingly, the proposed research study will use the following conceptual framework to guide and direct the study. Conceptual Framework

Research Questions

How does capital structure impacts firm’s profitability?

How does financial impacts firm’s profitability?

Research Methodology

Research methodology deals with all processes and procedures applied in the research for addressing the research problem and realizing the research aim and objectives. It is essential to select the appropriate research methodology because the chosen research methodology can influence the outcome of the research study. Correspondingly, the subsequent section explains and justifies the research methodology used in the proposed research study.

Research Approach

As per Denzin & Lincoln (2011), it has been argued that the choice of a suitable research approach is critical for successfully conducting a research study and drawing reliable findings. Notably, there are two kinds of broad research approaches that include deductive and inductive research approaches. The proposed research study will be based on a reasoned research approach. The deductive research approach has been considered an ideal choice for the proposed research because this approach involves the development and testing of hypotheses and helps in explaining the relationship between the two or more variables. Since the proposed research study aims to establish the relationship between profitability, and capital structure, and financial leverage, the deductive approach is considered to be more suitable than the inductive method.

Research Design

As far as the research design is concerned, quantitative and qualitative are the two most commonly applied research designs. Accordingly, the proposed research can be argued to be quantitative. This is because quantitative analysis is objective and uses non-textual data, then analyzed using statistical tools. The use of statistical tools to analyse the data further contributes to the high generalizability and verifiability of the research findings (Creswell, 2013). Also, the quantitative research method is often used in conjunction with the deductive approach.

Sample and Data collection

Data collection is an essential phase in a research study. The researcher needs to ensure that the collected data are relevant and reliable. The sample of the proposed research studies will include 200 companies from the Australian freight industry that will be selected non-randomly for the proposed research. Also, the proposed research study will involve the use of secondary data for analysis and interpretation purposes. Data for the proposed research study will include the use of annual financial reports of the companies from the Australian freight industry for the period 2010 to 2019. These data will be obtained through online research, including the official websites of the companies and from relevant databases.

Variables

The proposed research study will use profitability as the dependent variable, which will be measured using ROA. ROA, as the measure of profitability, has been considered in the study because the majority of the tasks in the past have used ROA as a measure of profitability. The proposed research study will use capital structure and financial leverage as the independent variables. In this regard, the proposed research study will use the debt to equity ratio and debt to total assets ratio as the measure of the capital structure. These two capital structure measures have been considered in the proposed study because these measures are identified to be the most commonly used measure of capital structure. In a similar context, the proposed research study will use long term debt ratio and short term debt ratio as the measure of financial leverage because studies in the past have used these two measures to investigate the impact of economic influence on the firm’s performance.

Data Analysis

Data analysis is perhaps the most critical element of a research study. This is because even if the data collected in the study are relevant and reliable. Still, the data analysis is performed poorly and inefficiently; it can lead to invalid findings. Hence, it is essential to place adequate attention when selecting data analysis tools and techniques. The proposed research study will use inferential statistical tools for the analysis of the collected data. Accordingly, the proposed research will use descriptive statistics, correlation, and regression analysis. Correlation in the study will determine the strength and direction of the linear relationship between the variables. On the other hand, regression analysis will predict the dependent variable's changes relative to the difference in independent variables. All statistical analyses in the proposed study will be run on the SPSS data analysis package.

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Time Frame and Cost

Since the proposed research study is based on secondary data, only a nominal cost is likely to complete the project.

Project Timeline

References

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Arabahmadi, F. & Arabahmadi, A. (2013). The relationship between capital structure and profitability (Case Study in Tehran Stock Exchange). Technical Journal of Engineering and Applied Sciences, 3(16), 1787-1789.

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