Research Paper

Debt level and firm performance: A study on low-cap firms listed on

the Kuala Lumpur stock exchange

Deowita Sabin
School of Accounting and Business Management
FTMS College, Malaysia
deowita@yahoo.com

Hassan Miras
School of Accounting and Business Management
FTMS College, Malaysia
hassan.miras@gmail.com

Abstract

Capital structure deals with the financing decision on the mixture of debt and equity, which plays a
vital role for the growth of a firm. Various studies are conducted on the impact of capital structure
on firm performance that had revealed mixed and contradictory results. Most empirical studies
focus on large corporations with few studies on low market capitalized firms. The purpose of this
study is to investigate the impact of debt level on firm profitability (ROA, ROE and NPM) and
liquidity (CR, QR, CCC) of low market capitalized firms listed on the Kuala Lumpur Stock Exchange
(Bursa Malaysia). A sample of 50 low-cap firms were chosen using a quota sampling based on
sectors. The study used secondary data with annual figures from annual reports from 2010 to
2013. Results generated using E-views 6.0 shows that debt level has a negative correlation with CR,
QR, CCC, ROE, ROA and NPM. A multiple regression model using a cross section fixed panel data
technique shows that debt level have a significant positive impact on QR but a significant positive
impact on CCC. The gearing level has a significant negative impact on ROE, ROA and NPM. The
study attempts to explain the results with the support of various capital structure theories and
shows that the mixture of debt and equity has a significant impact on the profitability and liquidity
of low-cap firms in the Kuala Lumpur stock exchange. This would help managers of low cap firms
in considering the debt level that could improve the profitability and liquidity.

Key Terms: Debt level, Gearing, Debt-to-equity, Current Ratio (CR), Quick ratio (QR), Cash
Conversion Cycle (CCC), Return on Asset (ROA), Return on Equity (ROE), Net
Profit Margin (NPM), Liquidity, Profitability, Capital Structure

1. Introduction

With the emergence of research in the area of finance, studies on firm capital structure
have attracted significant attention. Various studies were conducted to analyze the effect of
capital structure decision on firm performance (Khan, 2011). Debt and equity financing are the
two main classifications of sources of finance, and studies show contradictory results on the
firm performance (Simerly and Li, 2000 and Hadlock and James, 2002). Decision about optimal

Page 1
capital structure is one of the most challenging and difficult issues facing companies with the
decision related to the growth (Pouraghajan, Malekian and Bagheri, 2012). Many studies have
been conducted on the determinants of an optimal capital structure (Harris and Ravi, 1991;
Bevan and Danbolt, 2000; Omet and Nobanee 2001 and Antonion et. al., 2002), and most of
them focus on large corporations. With limited studies on small firms, this research attempts to
investigate the impact of debt level on firm performance in low market cap companies listed in
Bursa Malaysia to close down the literature gap.

SMEs around the world play an important role for the development of an economy. A
study conducted by Manan (2010) on leverage in small and medium enterprises (SMEs)
revealed that Malaysian SMEs were generally highly levered, and as a result was affecting the
economic growth of the country. Companies with low market cap will continuously look for
additional finance such as debt or equity finance for business growth. Champion (1999) stated
that the use of leverage can improve the performance of the firm. However, company with high
debt level may face higher risk in the future and lead the company towards bankruptcy (Ahmad,
Abdullah and Roslan, 2012). This issue encouraged the researchers to investigate debt level on
firm performance while focusing on low market cap companies in Malaysia.

The relationship between debt level and firm performance is an important unsolved
issue in the field of finance. It is vital to know how low market cap companies in Malaysia handle
their capital structure towards growth of business. Gleason et al., (2000) stated that the
managers decision on different debt and equity level in a capital structure is a specific strategy
for improved performance. However, most firms struggle to reach an optimal capital structure
in order to minimize cost of capital and maximize firm value while improving its competitive
advantage in the market place. The increasing leverage by taking debt enables the firm to have
positive implications on firm performance (Ross, 1977, Heinkel, 1982, and Noe, 1988). This
result is also supported by Hadlock and James (2002) where they conclude that companies
prefer debt financing because they expect a higher return. Champion (1999) stated that the use
of leverage is one way to improve firm performance.

This study will attempt to recommend on ways to manage their debt levels within the
capital structure. Studying the relation between capital structure decisions and firm
performance assist managers and investors to differentiate and identify comparative strengths
of particular effects of debt level on the firm performance. This would also help the firms to take
an optimal capital structure decision in specific circumstances and enable to assess the relation
between debt level and shareholders wealth since wealth maximization for shareholders is the
main objective of a manager (Kinsman and Newman, 1999).

Hence, the research aim to study the debt level and firm performance on low market cap
firms in Malaysia with two specific objectives stated below;

[1] To analyze the correlation between debt level and firm performance (profitability and
liquidity) of low market cap companies in Malaysia
[2] To examine the impact of debt level on profitability of low market cap companies in
Malaysia.
[3] To examine the impact of debt level on liquidity of low market cap companies in Malaysia.

2. Literature Review

2.1 Theoretical literature review

Capital structure decision is based on the use of mixture of debt, equity or a hybrid of
the instruments to finance for the growth of the business. Modigliani and Miller (1958) believed
that equity and debt financing decision add no value in a firm and therefore is not a concern for

Page 2
the managers. They stated that the value of the firms performance depends on the profitability
and not on its capital structure. However, critical investigations in the past few decades have
revealed that there is correlation between capital structure decisions and firm value (Ahmad,
Abdullah and Roslan, 2012).

Modigiliani and Miller (1958) in M&M proposition I, argues that on a perfect market
conditions with no taxes, no transaction costs and homogenous expectations, a firms capital
structure would have no impact on the firm value. Their arguments state that the value of a firm
totally depends on the companys performance and is independent from financing and dividend
policy. By relaxing the assumption of no taxes, Modigliani and Miller (1963) later suggested that
firms should increase debt level to maximize the firm value by maximizing the interest tax
shield. However, the firm's total deductible expenses are limited to income and the value of debt
tax shields may be affected by the level of other non-debt expenditures that are also deductible.

Debt is a loan agreement which is a liability to the firm and an obligation to repay
specified amount at a particular time (Ross, Westerfield and Jaffe, 2005). The Interest paid on
the debt is a deductible expense for tax computation. Hence, the tax encourages the utilization
of debt as it creates a tax subsidy on the interest expense that is positively related to the tax rate
(Cloyd, Limberg and Robinson, 1997).

According to trade-off theory, a firms target capital structure is determined by

balancing debt tax shields against cost of bankruptcy (Myers, 1984). The decision to borrow
involves making a trade-off between the expected tax savings associated with interest
deductions and the economic costs associated with increased debt that have greater risk of
bankruptcy (Cloyd, Limberg and Robinson, 1997). Even though debt gives a tax benefit to the
firm, it also put pressure on the firm with the high interest expenses. The financial distress cost
may offset the advantages of debt (Ross, Westerfield and Jaffe, 2005).

The pecking order theory by Myers and Majluf (1984) highlighted the preference of the
type of financing used by firms. According to Myers and Majluf (1984), firms should prefer
utilize internal funds from its retained earnings. Debt should only be issued when internal funds
deplete and new equity finance should be raised as the last option. Empirical test by Baskin
(1989) which showed that the firms with higher past profitability tend to have lower leverage.

Jensen and Meckling (1976) stated that in the decision about a firm capital structure, the
agency conflicts between shareholders and managers is affected by the level of debt, as it
encourage or limit managers to make decisions in the interest of shareholder and their
operating decision which can affect the firm performance. Fleming et al. (2005) stated that
agency cost between equity holders and owner-mangers can be reduced by increasing the
owner-managers' proportion in equity.

Nevertheless, the conflicts between equity holders and debt holders would be more
complicated. Equity holders have residual claim on cash flow from the projects they invest on
and they may accept projects with high risk that increase firm value (Zhang and Li, 2008).
However, debt holders do not only share profits and earnings with equity holders but also have
a fixed claim on cash flows in the form of interest. This conflict between equity holder and debt
holder may affect a firm's decision on investment, financing strategy and dividend distribution
(DeMarzo and Fishman, 2007). Therefore, Jensen and Meckling (1976) stated that the optimal
level of debt is when the debt is utilized to the point where marginal wealth benefits of tax
subsidy equals the marginal wealth effects of agency costs. The agency and asymmetric
information theories suggested that the using of debt enable the firm to perform well (Phillips
and Sipahioglu, 2004).

Page 3
2.2 Empirical literature review

2.2.1 No relation between debt level and firm performance.

In line with Modigliani and Miller (1958) capital structure irrelevancy theory, Krishnan
and Moyer (1997) found that there is no significant correlation between debt level and firm
performance. Using four different measures of corporate performance (Return on equity,
Return on invested capital, pre-tax operating profit margin and market return on the stock) the
result provides weak support for the static tradeoff theory and the pecking order theory. They
also argued that both profitability performance and capital structure are influenced by the
country of origin which contradicts with observations from Bartlett and Ghoshal (1989) and
Ohmae (1990) observation.

Marsh (1982) and Walsh and Ryan (1997) stated that companies with high proportion
of fixed assets would take advantage by using more debt. Nonetheless, this research found that
no significant relationship between the debt level as capital structure and financial performance
which is consistent with Miller (1977) as the advantages to corporate tax will be offset by the
personal income tax, implying leverage irrelevancy to any firm.

2.2.2 Positive relation between debt level and firm performance

In contrast to irrelevancy theories, studies have shown positive relationship between

debt level and firm performance. Chen (1998) found out that the impact of liability-asset ratio
cause high interest cost, low profitable and difficult for enterprise to earn money. However, Holz
(2002) found that the rising liability-asset ratio in the determination of profitability is
significantly positive with debt enabling firm managers to finance their project and maximize
the performance. Similarly, Dessi and Robertsons (2003) study on debt, incentives and
performance found a positive correlation between debt and firm performance. Moreover,
Zwiebel (1996) stated that debt is important because it has a value as a valuable managerial
incentives of mechanism for firms as the low growth firms may attempt to depend on the
borrowing for utilizing the expected growth opportunities and investing borrowed funds in
profitable projects, increasing firm performance.

Margaritis and Psillaki (2010) studied on capital structure, equity ownership and firm
performance found that debt capital structure has a positive relationship with firm performance
in consistent with agency theory by Jensen (1986). Margaritis and Psillaki (2010) stated that
debt is more important for firm performance for industries with less growth opportunity. Debt
has a basic different role on performance between firms with the few and those with many
growth opportunities (McConnell and Servaes, 1995).

2.2.3 Negative relation between debt level and firm performance

On the other hand, studies also proved a negative relationship between debt level and
firm performance. Although firms preference to debt financing due to the anticipated higher
return (Hadlock and James, 2002), it also bring in bankruptcy cost such as direct and indirect
costs (Titman, 1984). A study by Abor (2005) revealed a negative impact of long term debt on
firm performance due to the high interest rate. Meanwhile, short-term debt shows a positive
impact as firms finds short-term instruments cheap and easy to access.

Evidence from Rao, Al-Yahyaee and Syed (2007) also evidence a negative relationship
between debt level and firm performance and argued that countries with no personal taxes and
low corporate taxes tend to use low debt since there is minimal tax advantage from using
financial leverage. They also found that the interest expense is relatively higher compared to
western countries, thus discouraging the use of debt and adversely impacting profitability. The

Page 4
result contradicts with trade-off theory of capital structure as the level of debt is attributed with
the high cost of borrowing. The tax savings that a firm gains by using debt does not seem to be
sufficient to outweigh the costs of using debt including the high interest cost.

2.3 Theoretical Framework

Current Ratio (CR)
Liquidity Quick Ratio (QR)
Cash Conversion Cycle (CCC)
Debt Level
(Debt-to-Equity) Firm Performance

Return on Equity (ROE)

Profitability Return on Asset (ROA)
Net Profit Margin (NPM)

Figure 1: Conceptual Framework

In order to examine relationship between debt level and firm performance on low
market cap companies in Malaysia, this researcher developing a framework. In this research, the
independent variable is debt level that measured by total debt to total equity while the
dependent variable is firm performance which refers to firm liquidity and firm profitability.
Firm liquidity measured by CR, QR and CCC while firm profitability measured by ROE, ROA and
NPM. Based on the above framework, the following hypothesis is developed to examine the
impact of debt level on firm performance:
H1: There is negative impact of DL on CR.
H2: There is positive impact of DL on QR.
H3: There is negatively impact DL on CCC.
H4: There is negative impact of DL on ROE.
H5: There is negative impact of DL on ROA.
H6: There is positive impact of DL on NPM.

3. Research Design and Methodology

This research will conduct an explanatory study to establish and explain the causal
relationship between variable. This allowed the researcher to examine the correlation between
debt and firm performance and also the impact of debt level on profitability and liquidity of a
firm (Saunders, Lewis and Thornhill, 2009). Cross-sectional studies enable the researcher to
investigate debt level across different companies listed in Bursa Malaysia while longitudinal
studies allowed the researcher to investigate the annual data from different time period ( Yee
and Debbie, 1996). A causal comparative research design has been used to enable the
researcher to examine the interaction between independent variable and its influence on
dependent variable (Williams, 2007). Furthermore, the quantitative approach as data collection
maintains the assumption of an empiricist paradigm (Creswell, 2003). The experiment in this
research will involve setting hypothesis, selecting a sample of companies from different sectors
and specific measurement on independent and dependent variables (Saunders, Lewis and
Thornhill, 2009)

The study uses secondary data from annual reports of companies from 2010 to 2013 to
calculate relevant ratios. Figures were extracted for 50 low cap companies listed in the Bursa
Malaysia using a proportional stratified sampling technique to represent a population of 790
small cap firms. Market cap is used as a measurement of corporate size (Yasmin and Yusuf,
2008) and include listed companies on Bursa Malaysia with a market capitalization of $300
million to $2 billion (Yasmin and Yusuf, 2008).

Page 5
 External stakeholders normally evaluate a firm's ability based on its performance (Bonn,
2000). Firm performance can be defined as the outcomes that achieve the firm objective (Lin et
al., 2008) and is related with growth, survival, success and competitiveness (Dobbs and
Hamilton, 2006; Wolff and Pett, 2006). Firms use different methods to measure their
performance and can be financial or non-financial measures (Darroch, 2005; Bagorogoza and
Waal, 2010; Bakar and Ahmad, 2010). However, firms prefer more to adopt financial indicators
to measure their performance (Grant et al., 1988; Hoskisson, 1990). Table 1 below shows the
financial indicators used to for the variables to measure debt level and firm performance.

Independent Measures the amount of debt

Debt-to-equity relative to equity Gearing
Variable
Measures the ability to meet its
Current ratio current liabilities with current
assets.
Measures the ability to meet its
current liabilities with current
Quick Ratio Liquidity
assets but exclude inventories
from current assets.
Measures the number of days it
Cash Conversion
Dependent takes to convert the resources into
Cycle
Variables cash
Amount of net income available to
Return on Equity shareholders as a percentage of
total equity.
Measures the profitability relative
Return on Asset Profitability
to the assets of the company
Measure the ability to generate net
Net Profit Margin profit relative to the sales level.
Table 1 Independent and dependent variables

Analysis and results will discuss the descriptive statistics, normality tests as well as
correlation between the variables. The study applies panel data firm fixed-effect model
regression technique using 200 observations (50 companies for 4 years). Durbin-Watson test
will be used to check for autocorrelation. The relationship between debt level and firm
performance will be investigated using the following regression models.

Current Ratio i,t = 0 + 1Debt-to-equity i,t +e i,t

Quick Ratio i,t
Cash Conversion Cycle i,t
Return On Equity i,t
Return On Assets i,t
Net Profit Margin i,t
= 0 + 1Debt-to-equity i,t +e i,t
= 0 + 1Debt-to-equity i,t +e i,t
= 0 + 1Debt-to-equity i,t +e i,t
= 0 + 1Debt-to-equity i,t +e i,t
= 0 + 1Debt-to-equity i,t +e i,t

4. Results and Discussion

4.1. Descriptive statistics

Table 2 below shows the descriptive statistics for the 200 observations for each variable
used in the analysis. It shows that the average debt level for the 50 low market cap companies is
41 percent approximately with a standard deviation of 48 percent. The overall liquidity position
of the companies are shown relatively good with an average current ratio of 2.33:1 and an
average quick ratio of 1.46:1. However, the mean cash conversion cycle days approximate to
144 days. Average return on equity and return on asset stands at 12.4% and 7.1% respectively.
Average net profit margin is 16.1% for the period analyzed. Skewness values for DL, CR, QR and
CCC shows the data is slightly positively skewed, while ROE and ROA is slightly negatively
skewed. Kurtosis analyzing the peakedness of the distributions shows that DL, CR, CCC, ROE,
ROA and NPM have positive kurtosis and will be referred as leptokurtic distributions (Lomax

Page 6
and Vaughn, 2012). The Jarque-Bera test explain if the sample data follows a normal
distribution and the results shows that it is significant indicating all variables are normally
distributed.

DL CR QR CCC ROE ROA NPM

Mean 40.87 2.33 1.46 143.85 12.40 7.11 16.12
Median 24.86 1.74 1.04 95.99 11.46 6.22 10.11
Maximum 268.06 10.58 7.51 1448.45 109.00 36.38 377.88
Minimum 0.00 0.48 0.11 -1671.65 -73.00 -25.86 -181.41
Standard Deviation 48.16 1.75 1.29 271.98 17.15 7.28 39.15
Skewness 2.10 2.09 2.44 0.96 -1.00 -0.58 5.02
Kurtosis 8.10 7.78 9.69 20.37 16.79 9.60 50.36
Jarque-Bera 363.33 335.68 571.57 2544.99 1616.90 374.39 19532.11
Probability 0.00 0.00 0.00 0.00 0.00 0.00 0.00
Table 2: Descriptive statistics

4.2. Correlation

Correlation analysis is defined as the degree of relationship between two variables

(Sharma, 2005). Table 3 presents correlation matrix showing Karl Pearson's coefficient of
correlation and significance level.

VARIABLE DL CR QR CCC ROE ROA NPM

1.000
Debt-to-equity (DL)
-----
-0.420 1.000
Current ratio (CR)
(0.000) -----
-0.412 0.836 1.000
Quick ratio (QR)
(0.000) (0.000) -----
-0.113 0.383 0.027 1.000
Cash Conversion Cycle (CCC)
(0.111) (0.000) (0.708) -----
-0.270 0.041 0.072 -0.068 1.000
Return on Equity (ROE)
(0.000) (0.566) (0.309) (0.337) -----
-0.418 0.266 0.322 -0.054 0.856 1.000
Return on Asset (ROA)
(0.000) (0.000) (0.000) (0.446) (0.000) -----
-0.217 -0.009 0.015 -0.315 0.313 0.291 1.000
Net profit Margin (NPM)
(0.002) (0.898) (0.836) (0.000) (0.000) (0.000) -----
Table 3: Correlation matrix

Results show that debt level has a significant negative correlation between current ratio
and quick ratio, although the relationship is moderate. This explains that companies with high
level of debt have poor liquidity position as cash will be utilized to pay interest on debts. On the
other hand, highly liquid firms tend to have lower debts as the need to raise short-term debt
finance is low or the high liquidity could be used to gradually decrease debt levels (Sarlija and
Harc, 2012).

Profitability ratios also show a significant negative correlation with debt level. Even
though the correlation of ROE, ROA and NPM with DL is significant, correlation coefficient
shows a weak negative correlation. According to Matariranu (2007), employing more on debt
will result in higher cost of debt and lead to decrease in profitability. Companys in ability to to
pay interest to the investor will decrease the value of equity.

Page 7
4.3. Regression analysis

Regression analysis has been conducted by using panel data in E-Views 6.0 to test the
research hypothesis. The impact of debt level on firm performance was determined with a
cross-section fixed effects model.

4.3.1 Impact of debt level on liquidity

4.3.1.1. Debt level on current ratio

Dependent Variable: Current Ratio

Variable Coefficient Std. Error t-Statistic Prob.
Debt-to-equity -0.004 0.003 -1.522 0.130
Constant 2.517 0.133 18.964 0.000
R-squared 0.839 F-statistic 15.512
Adjusted R-squared 0.785 Prob(F-statistic) 0.000
Durbin-Watson stat 1.832

Table 4: Regression output (Model 1)

Debt-to-equity ratio is the total liabilities of a firm to its shareholders equity while CR
refers to the ability of the company to pay off their current liabilities by using current asset such
as cash, inventories and other. Regression equation shows that debt level has no significant
impact on current ratio (P-value = 0.130> 0.05) indicating that the changes in the capital
structure would not improve or deteriorate the liquidity position of a company. This contradicts
with the findings of Sarlija and Harc (2012) that the increase in debt-to-equity ratio will reduce
firm liquidity in term of current ratio in the case when the inventory is reduce from the current
asset to pay off their liabilities.

Current Ratio i,t = 2.517 - 0.004 Debt-to-equity i,t + e i,t

(0.000) (0.130)

4.3.1.2. Debt level on quick ratio

Dependent Variable: Quick Ratio

Variable Coefficient Std. Error t-Statistic Prob.
Debt-to-equity -0.004 0.002 -2.446 0.016
Constant 1.622 0.076 21.395 0.000
R-squared 0.903 F-statistic 27.773
Adjusted R-squared 0.871 Prob(F-statistic) 0.000
Durbin-Watson stat 1.918

Table 5: Regression output (Model 2)

The above regression result reveals that debt level has a negative significant impact on
quick ratio or acid test ratio (P-value of 0.016 < 0.05). An adjusted R-square of 0.871 indicates
that 87 percent of the variance in quick ratio can be explained by variations in debt-to-equity
ratio. In addition, the Durbin-watson statistic of 1.918 lies between 1.75 and 2.25, meaning that
there is no auto correlation with the error term. Significance level of the F-statistic (0.000)
shows the strength of the corresponding regression.

Page 8
 Quick Ratio i,t = 1.622 0.004 Debt-to-equity i,t +e i,t
(0.000) (0.016)

Kajananthan and Achchuthan (2013) have found significant impact between QR and
debt-to-equity ratio. However, debt equity ratio was used as dependent variable and QR as
independent variable. They found that quick ratio has significant impact on debt to equity
meaning that decision making on capital structure is highly depending on the liquidity
management. Nevertheless, in this research, the increase of debt to equity meaning that the
company have problem in liquidity while the firm with high liquidity will reduce the debt level
(Sarlija and Harc, 2012). This result related with pecking order theory, where the company go
for external funds only when internal fund are depleted.

4.3.1.3 Debt level on cash conversion cycle

Dependent Variable: Cash Conversion Cycle

Variable Coefficient Std. Error t-Statistic Prob.
Debt-to-equity 2.929 0.516 5.672 0.000
Constant 24.120 23.396 1.031 0.304

R-squared 0.794 F-statistic 11.471

Adjusted R-squared 0.725 Prob(F-statistic) 0.000
Durbin-Watson stat 1.950

Table 6: Regression output (Model 3)

Even though there was no significant pearson correlation between debt level and cash
conversion cycle, regression result shows otherwise. The beta coefficient shows a positive,
indicating an increase in debt levels leads to increase in cash conversion cycle. Adjusted R-
square of 0.725 indicates more than 72 percent of the variation in cash conversion cycle can be
explained by changes in debt levels.

Cash Conversion Cycle i,t = 24.120 + 2.929 Debt-to-equity i,t +e i,t

(0.304) (0.000)

Manoori and Muhammad (2012) found that debt ratio also is positively related with
CCC. Ebben and Johnson (2011) stated that CCC was found to be significant related with debt
financing because firm with more liquid require less debt or equity financing. The high level of
debt meaning that the sample company with low market cap might use long term debt to
finance their capital structure. Furthermore, the increase of debt level in a company will also
increase the cost of external financing (Jensen and Mackling, 1976). The longer the CCC may
cause the company associated with more opportunity cost and less efficiency in working capital
management (Manoori and Muhammad, 2012).

4.3.2 Impact of debt level on profitability

4.3.2.1. Debt level on Return on equity

Dependent Variable: Return on Equity

Variable Coefficient Std. Error t-Statistic Prob.
Debt-to-equity -0.196 0.040 -4.902 0.000
Constant 20.418 1.813 11.262 0.000

Page 9
 R-squared 0.688 F-statistic 6.584
Adjusted R-squared 0.584 Prob(F-statistic) 0.000
Durbin-Watson stat 2.188

Table 7: Regression output (Model 4)

Forecast of the impact of debt level on Return on equity shows an R-square of 0.688 and
an adjusted R-square of 0.584 meaning that 58 percent of the variance in ROE can be explained
by variations in debt level. Durbin-Watson statistic is 2.188 meaning that the data is acceptable
because indicating no auto correlation (Makridakis and Wheelwright, 1978). The strength of
corresponding of regression refers to value of the F-statistic which is 6.584 and significant.

Return on Equity i,t = 20.418 0.196 Debt-to-equity i,t +e i,t

(0.000) (0.000)

Results show that debt level has a negative impact on return on equity (P-value = 0.000
< 0.01%). This means an increase in debt level by 1 % is expected to decrease ROE by 19.6%.
The result is in conformation with Abor (2005) who found that negative impact of long term
debt on ROE, but a positive impact from short term debts. Arbiyan and Safari (2009) also had
identified negative impact of financial liabilities on ROE for 100 companies in Iran. Moreover,
Moscu (2014) found that debt level has negatively impact on ROE. The negative impact means
that the decrease in debt level will increase on ROE and vice versa. This result related with
pecking order theory which is the companies with lower debt level more prefer internal finance
as source of investment financing and second place choose debt (Myers and Majluf, 1984). The
increase in debt level will increase the bankruptcy cost and if the company fail to meet any debt
obligation will see their profitability decreasing.

4.3.2.2. Debt level on Return on Asset

Dependent Variable: Return on Asset

Variable Coefficient Std. Error t-Statistic Prob.
Debt-to-equity -0.071 0.015 -4.643 0.000
Constant 10.024 0.696 14.408 0.000
R-squared 0.745 F-statistic 8.719
Adjusted R-squared 0.660 Prob(F-statistic) 0.000
Durbin-Watson stat 2.335

Table 8: Regression output (Model 5)

Regression output on Return on Asset is also found to be significant with a beta

coefficient of -0.071, hence indicating a negative impact on Return on Assets. Adjusted R-square
is slightly lower at 0.660, meaning that 66 percent of variations in Return on assets can be
explained by variations in the leverage. Durbin-Watson statistic of 2.335 shows no sign of auto
correlation.

Return on Asset i,t = 10.024 0.071 Debt-to-equity i,t +e i,t

(0.000) (0.000)

In contrast, Moscu (2014) found that ROA is positively influenced by the debt-to-equity
meaning that some companies use debt to invest the borrowed funds in profitable project and
directly increase firm efficiency. The trade-off theory suggests the firm to use debt as much as
possible in order to maximizing interest tax shields to against cost of bankruptcy (Myers, 1984).
However, the increase in debt also has greater risk of bankruptcy. Output shows that debt to

Page 10
equity has negative impact on return on asset and statistically significant at 1% (P=0.000<0.01)
meaning that the increase of debt level will decrease the ROA. Abor (2007) also found similar
result which is all the measure of capital structure including debt to equity have significantly
negative impact on ROA. The increase in long term debt will lead to decrease in ROA because of
the higher cost of interest compared to short term debt (Abor, 2005).

Azhagaiah and Gavory (2011) found that debt-to-equity ratio have negative impact on
ROA in IT firms which divided based on asset sized (small, medium and large) and business
revenue. It was found that low income of IT firms with low expenses and free from debt are
more profitable. The IT firms with medium and large income but low debt level have perform
well by generating higher incomes. Therefore, the increase in debt fund significantly reduces the
net earnings of IT firms. Similarly, effect on profitability of low market cap companies becomes
more severe with high debt level as expenses increase and profitability decreases.

4.3.2.3. Debt level on Net Profit Margin

Dependent Variable: NPM

Variable Coefficient Std. Error t-Statistic Prob.
Debt-to-equity -1.021 0.117 -8.696 0.000
Constant 57.844 5.319 10.875 0.000
R-squared 0.486 F-statistic 2.815
Adjusted R-squared 0.313 Prob(F-statistic) 0.000
Durbin-Watson stat 2.080

Table 8: Regression output (Model 5)

Regression result in predicting the impact of debt level on net profit margin shows an
adjusted R-squared of 0.313, which is generally low. The low R-squared indicates that only
31.3% of variance in net profit margin can be explained by the variations in capital structure.
Durbin-watson statistic shows there is no issue of auto correlation in the model.

Net Profit Margin i,t = 57.844 1.021 Debt-to-equity i,t +e i,t

(0.000) (0.000)

However, the regression output shows that debt level has significant negative impact on
net profit margin which is -0.1021 and statistically significant which at 1% 0.000 (P-value =
0.000<0.001) meaning that the decrease or increase in DL will influence the NPM. For instance,
the lower of debt level will increase the NPM and directly increase the firm value. Kinsman and
Newman (1998) stated that firm should choosing low debt or zero debt to maximise its firm
value. The increase of debt level gives advantages to the firm in order to increase their level of
investment. However, the higher debt-to-equity ratio also may increase the net profit margin. In
this study, the sample companies choose the high debt level as capital structure in order to
finance their business. This related with trade-off theory because using high debt level
nevertheless, it will reduce their net profit margin. Abor (2005) stated that the increase debt
level cause the increase in cost of debt and directly have a significant reduction in profit
margins. In addition, the use of borrowed capital may increase the risk for the firms to
possibility going bankruptcy because capital creates fixed expenses such as interest expense
that should be paid by the firm (Eriotis, Frangouli and Neokosmides, 2002). NPM refers to total
income minus all expenses including interest expense and tax. Hence, high interest expenses
will decrease the firm net profit margin and reduce profitability.

Page 11
5. Conclusion and Recommendation

The main aim of the research was to analyze the impact of debt level on a firms
profitability and liquidity for low cap companies listed in the stock. And it has been found that
the debt level is relevant to the profitability and liquidity of the 50 firms chosen from Malaysian
stock exchange.

5.1 Correlation between debt level and firm performance.

Dependent Variable Correlation Significant / Not Significant

Current Ratio (CR) Negative Significant
Quick Ratio (QR) Negative Significant
Cash Conversion Cycle (CCC) Negative Not Significant
Return on Equity (ROE) Negative Significant
Return on Asset (ROA) Negative Significant
Net Profit Margin (NPM) Negative Significant
Table 9: Correlation analysis summary

Table 9 shows the summary of correlation between debt level and firm performance.
Debt level has negative correlation CR, QR, CCC, ROE, ROA and NPM meaning that the increase
in debt level will decrease the firm performance. The firm performance refers to the firm
liquidity (CR, QR and CCC) and profitability (ROE, ROA and NPM) in low market cap companies.
Some researchers found that debt level is not significant with firm profitability because the firm
prefer firstly retained earnings as main source of finance as suggest by the pecking order theory
(Sogorb and Lopez, 2003). However, in this study debt level has a significant correlation with all
the dependent variable except the CCC. This study assumes that the increase in debt level is
likely to face liquidity problems. However, the high liquidity in the company may reduce the
debt level. This result is consistent with Frieder and Martell (2006) which is negative
correlation between debt level and firm performance. The low market cap companies tend to
increase their debt level in order to operate their business and gain from the tax benefit.
Nevertheless, the increase in debt will reduce firm liquidity; increase the company's financial
burden such as interest payment and the riskiness of the firm, which can reduce the firm value.

Negative correlation between debt level and ROE, ROA and NPM is also statistically
significant. This shows that companies with high debt level of low market cap companies tend to
have low profitability and liquidity and vice versa. The increase in debt level enable companies
with low market cap getting tax benefits that related with trade-off theory and higher debt level
will push towards growth (De Mooij, 2011). However, when the level of debt is too high it might
result in companies default in debt repayments and go towards bankruptcy. Low market cap
companies might maintain low debt level when they prefer the pecking order theory to raise
finance (Myers and Majluf, 1984).

5.2 The impact of debt level of firm performance.

Dependent Variable Impact Significant / Not Significant

Current Ratio (CR) Negative Not Significant
Quick Ratio (QR) Negative Significant
Cash Conversion Cycle (CCC) Negative Significant
Return on Equity (ROE) Negative Significant
Return on Asset (ROA) Negative Significant
Net Profit Margin (NPM) Negative Significant
Table 10: Regression analysis summary

Page 12
 The above table shows a summary of the regression output indicating the significance.
Overall the study showed that debt levels have a negative impact on profitability and liquidity.
The low market cap companies preference of more debt financing can have an undesirable
effect on the liquidity position, which is consistent with the finding of Sarlija and Harc (2012)
and Kajananthan and Achchuthan (2013). In addition, the positive impact of these companies on
firm performance means that the increase in debt level will extend or lengthen the CCC due to
the high cost of debt and reduce efficiency in working capital (Manoori and Muhammad, 2012).
Therefore, debt level will negatively impact on firm performance where the high debt level may
cause firm liquidity to decrease and affect the firm performance.

The study also showed that debt level has negative impact on firm profitability referring
to ROE, ROA and NPM. It means that the high debt level will affect firm profitability that directly
reduce firm performance. The trade-off theory suggests that a company should take high level of
debt to reduce the tax expenses. However, debt financing include a fixed cost that the firm need
to pay off. Thus, the companys failure to service the debt can directly lead to decrease in
profitability and closer to bankruptcy. Moreover, the increase debt level can reduce the firm
profit margin because of fix expenditure such as the interest expense payment attached with
debt.

Overall, the research achieved the objective, which is to identify the relationship
between debt level and firm performance of low market cap companies and investigate the
impact of debt level on firm performance of the 50 companies in the sample. Based on the
findings it is recommended for low market cap firms to have low level of debt if the aim is to
improve profitability and/or liquidity. If it is required to raise finance, it is recommended to go
with the pecking order, which is to first utilize the internal funds available.

The limitation in this study needs to be considered for further research. Number of firms
needs to be increased to have a better representation of the population (Krejcie and Morgan,
1970). Similar studies can also be conducted on, medium and large market cap companies to
investigate how the results differ. Scope can be expanded to investigate debt level in different
context such as analyzing the impact of debt level on cost of capital and its impact on firm
performance. Other ratios measuring firm performance can also be considered. More
importantly, causality tests need to be conducted to assess whether debt level effect firm
performance or if it is the other way round.

References

[1] Abor, J., 2005. The Effect of Capital Structure on Profitability: Empirical Analysis of
Listed Firms in Ghana. Journal of Risk Finance, 6(5), pp. 438-45.
[2] Abor, J., 2007. Debt policy and performance of SMEs: Evidence form Ghanaian and South
African firms. The Journal of Risk Finance, 8 (4), pp.364-379.
[3] Ahmad, Z., Abdullah, N.M.H. and Roslan, S., 2012. Capital structure effect on firm
performance: Focusing on customers and industrials sectors on Malaysian Firms.
International Review of Business Research Papers, 8(5), pp. 137-155.
[4] Antoniou, A., Guney, Y. and Paudyal, K., 2002, Determinants of Corporate Capital
Structure: Evidence from European Countries, University of Durham, Working paper, pp.
1-8.
[5] Arbabian A.A. and Safari., M. G., 2009. The effect of capital structure on profitability
Companies listed on the Iran Stock Exchange. Landscape Management, 330, pp. 175-
159.

Page 13
[6] Azhagaiah, R. and Gavoury, C., 2011. The impact of capital structure on profitability with
special reference to IT industry in India [pdf] Available at: http://www.fm-
kp.si/zalozba/ISSN/1581-6311/9_371-392.pdf [Accessed 24 April 2014].
[7] Bagorogoza, J., and Waal, A. D., 2010. The Role of Knowledge Management in Creating
and Sustaining High Performance Organisations the Case of Financial Institutions in
Uganda. World Journal of Entrepreneurship Management and Sustainable Development,
6 (4), pp. 307-323.
[8] Bakar, L. J., and Ahmad, H., 2010. Assessing the Relationship between Firm Resources
and Product Innovation Performance. Business Process Management Journal, 16(3), pp.
420-435.
[9] Baker, S.A., 1973. Risk, Leverage and Profitability. Review of Economics and Statistics,
55, pp. 503-507.
[10] Bartlett, C. A., and Ghoshal, S., 1989, Managing Across Borders: The Transnational
Solution. Harvard Business School Press,
[11] Baskin, J., 1989. An empirical investigation of the pecking order hypothesis. Financial
Management, 18, pp. 26-35.
[12] Bevan, A. and Danbolt, J., 2002, Capital Structure and its Determinants in the UK- A Deco
Positional Analysis, Applied Financial Economics 12: pp. 159-170.
[13] Bonn, I., 2000. Staying on Top: Characteristics of Long-Term Survival. Journal of
Organizational Change Management, 13(1), pp. 32-48.
[14] Bursa Malaysia, 2014. Listed companies. [Online] Available at:
http://www.bursamalaysia.com/market/listed-companies/company-
announcements/#/?category=all [Accessed 19 April 2014].
[15] Champion, D., 1999. Finance: the joy of leverage. Harvard Business Review, 77(4), pp.19-
22.
[16] Chen, Q., 1998. Guanyu guoyou qiye gaige de xingshi he tujing (On the shape and future
of SOE reform). Zhonggong Zhongyang Dangxiao Baogaoxuan, (4), pp. 220.
[17] Cloyd, C.B., Limberg, S.T. and Robinson, J.R., 1997. The impact of federal taxes on the use
of debt by closely held corporations. National tax Journal, 50(20), pp. 261-277.
[18] Creswell, J., 2003. Research design: Qualitative, quantitative and mixed methods
approaches. 2nd ed. Thousand Oaks, CA: SAGE Publications.
[19] Darroch, J., 2005. Knowledge Management, Innovation and Firm Performance. Journal
of Knowledge and Management, 9(3), pp. 101-115.
[20] De Mooij, R. 2011. Tax biases to debt finance: Assessing the problem. Fiscal Studies,
33(4), pp. 489-512.
[21] DeMarzo, P. and Fishman, M., 2007. Agency and Optimal Investment Dynamics. The
Review of Financial Studies, 20(1), pp151-188.
[22] Denscombe, M. (2007) The Good Research Guide. 3rd ed. Buckingham: Open University
Press.
[23] Dessi, R. and Robertson, D., 2003. Debt, Incentives and Performance: Evidence from UK
Panel Data. The Economic Journal, 113, pp. 903 - 919.
[24] Dobbs, M. and Hamilton, R.T., 2006. Small Business Growth: Recent Evidence and New
Directions. International Journal of Entrepreneurial Behaviour and Research, 13 (5), pp.
296-322.
[25] Ebben, J.J. and Johnson, A.C., 2011. Cash conversion cycle management in small firms:
Relationship with liquidity, invested capital and firm performance. Journal of Small
Business and Entrepreneurship, 24(3), pp.381-396.
[26] Eriotis, N., Frangouli, Z. and Neokosmides, Z.V., 2011. Profit margin and capital
structure: An empirical relationship. The Journal of Applied Business Research, 18(2),
pp. 85-88.
[27] Fleming, G., Heaney, R. and McCosker, R., 2005. Agency costs and ownership structure in
Australia. Pacific-Basin Finance Journal, 13, pp. 29-52.

Page 14
[28] Frieder and Martell, 2006. On capital structure and the liquidity of a firm's stock [pdf]
Available at: http://finance.eller.arizona.edu/documents/seminars/2005-
6/LFrieder.CapStructure-Liquidity04-06.pdf [Accessed 29 April 2014].
[29] Gleason, K.C., Mathur, L.K. and Mathur, I., 2000. The interrelationship between cultures,
capital structure, and performance: Evidence from European retailers'. Journals of
Business Research, 50, pp.185-91.
[30] Grant, R.M., Jammine, A.P. and Thomas, H., 1988. Diversity, Diversification, and
Profitability among British Manufacturing Companies 19721984. Academy of
Management Journal, 31, pp. 771801.
[31] Hadlock, C.J. and James, C.M., 2002. Do banks provide financial slack?. Journal of Finance,
57, pp. 1383-1420.
[32] Heinkel, R., 1982. A theory of capital structure relevance under imperfect information.
Journal of Finance, 37, pp.1141-50.
[33] Holz, C.A., 2002. The impact of the liability-asset ratio on profitability in China's
industrial state-owned enterprises. China Economic Review, 13, pp. 1-26.
[34] Hoskisson, K., 1990. Using History to Understand Theory: Are Considerations of the
Historical Generri of Strategy. Paper prepared for the E1ASM Workshop on Strategy,
accounting and control, Venice, Italy.
[35] Jensen, M. C and Meckling, W. H., 1976. Theory of the firm: managerial behavior, agency
costs and ownership structure. Journal of Financial Economics, 3, pp. 305-60.
[36] Jensen, M., 1986. Agency costs of free cash ow, corporate finance, and takeovers.
American Economic Review, 76, pp. 323329.
[37] Kajananthan, R. and Achchuthan, S., 2013. Liquidity and capital structure: Special
reference to Sri Lanka Telekom Plc. Advances in Management & Applied Economics,
3(5), pp. 89-99.
[38] Khan, A.G., 2011. The relationship of capital structure decision with firm performance: A
study of the engineering sector of Pakistan [pdf] Available at:
http://saicon2011.ciitlahore.edu.pk/Economics/11-1071%20abdul%20ghafoor.pdf
[Accessed 7 March 2014].
[39] Kinsman, M. and Newman, J., 1998. Debt tied to lower firm performance: Finding calls
for review of rise in debt use. Pepperdine University.
[40] Kinsman, M. and Newman, J., 1999. Debt level and firm performance: an empirical
evaluation. Paper presented at 28th Annual Meeting of the Western Decision Science
Institute, 1999, Puerto Vallarta, Mexico.
[41] Krejcie, R.V. and Morgan, D.,W., 1970. Determining sample size for research activities.
Educational and psychological measurement, 30, pp. 607-610.
[42] Krishnan, V.S. and Moyer, R.C., 1997. Performance, capital structure and home country:
an analysis of Asian corporations. Global Finance Journal, 8(1), pp. 129-143.
[43] Lin, C.H., Peng, C.H., and Kao, D. T., 2008. The Innovativeness Effect of Market
Orientation and Learning Orientation on Business Performance. International Journal of
Manpower, 29 (8), pp. 752-772.
[44] Lomax, R.G. and Vaughn, D.L.H., 2012. An introduction to statistical concepts. 3ed. New
York: Taylor & Francis Group.
[45] Makridakis, S. and Wheelwright, S. C.,1978. Interactive forecasting univariate and
multivariate methods. California: Holden-Day Inc.
[46] Manan, S.K.A., 2010. Study on Financing and Financial Performance of SMEs in Malaysia,
[pdf] Available at:
http://koleksi.uitm.edu.my/digital_public/THESIS24/SITI%20KHADIJAH%20BT%20A
B%20MANAN%2010_24.pdf [ Accessed 12 November 2013 ].
[47] Manoori, E. and Muhammad, J., 2012. Determinants of working capital management:
Case of Singapore firms. Research Journal of Finance and Accounting, 3(11), pp. 15-23.
[48] Margaritis ,D and Psillaki, M., 2010. Capital Structure, Equity Ownership and Firm
Performance ,Journal of Banking and Finance, 34, pp. 621-632.

Page 15
[49] Marsh, P., 1982. The Choice Between Equity and Debt: An Empirical Study. Journal of
Finance, 37 (1), pp. 12144.
[50] Matarirano, O., 2007. An Investigation into the impact of debt financing on the
profitability of small manufacturing firms in Bulawayo, Zimbabwe [pdf] Available at:
http://www.rbi-ssa.org/resources/data/SMME-Dev-p6-OMatarirano.pdf [Accessed 22
April 2014].
[51] McConnell, J., Servaes, H., 1995. Equity ownership and the two faces of debt. Journal of
Financial Economics, 39, pp. 131157.
[52] Academy of Business and Administration Sciences Conference, Vancouver.
[53] Miller, M.H. and F. Modigliani, 1966. Some Estimates of the Cost of Capital to the Electric
Utility Industry, 19541957. American Economic Review, 55 (3), pp. 333391.
[54] Miller, M.H., 1977. Debt and Taxes. Journal of Finance, 32 (2), pp.26175.
[55] Modigliani, F. and Miller, M., 1958. The cost of capital, corporation finance and the
theory of investment. American Economic Review, 6, pp. 261-297.
[56] Modigliani, F. and Miller, M., 1963. Corporate income taxes and the cost of capital: A
correction. American Economic Review, 53, pp. 443-53.
[57] Moscu, R.G., 2014. Capital structure and corporate performance of Romanian Listed
Companies. International Journal of Academic Research in Accounting, Finance and
Management Sciences, 4(1), pp.287-292.
[58] Myers, S.C. and Majluf, N.S., 1984. Corporate financing and investment decisions when
firms have information that investors do not have. Journal of Financial Economics, 12,
pp. 187-221.
[59] Myers, S.C., 1984. The capital structure puzzle. Journal of Finance, 39, pp. 575592.
[60] Myers, S.C., 2001. Capital structure. Journal of Economic Perspectives,15 (5), pp. 81-102.
[61] Noe, T., 1988. Capital structure and signaling game equilibria. Review of Financial
Studies,1, pp. 331-55.
[62] Ohmae, K., 1990. The Borderless World. London: Collins.
[63] Omet, G. and Nobanee, H., 2001, The Capital Structure of Listed Industrial Companies in
Jordan, Arabic Journal of Administrative Sciences, 8: pp. 273-289.
[64] Phillips and Sipahioglu., 2004. Performance implications of capital structure: evidence
from quoted UK organizations with hotel interests. The Service Industries Journal, 24
(5), pp. 31-51.
[65] Phillips, P.A. and Sipahioglu, M.A., 2004. Performance implications of capital structure:
Evidence from quoted UK organisation with hotel interest. Source: Service Industries
Journal, 24 (5), pp. 31-51.
[66] Pouraghajan, A., Malekian, E. and Bagheri, M. M., 2012. The Relationship between Capital
Structure and Firm Performance Evaluation Measures: Evidence from the Tehran Stock
Exchange. International Journal of Business and Commerce, 1 (9), pp. 166-181.
[67] Rao, N.V., Al-Yahyaee and Syed, L.A.M., 2007. Capital structure and financial
performance: Evidence from Oman. Indian Journal of Economies and Business, 6(1), pp.
1-14.
[68] Ross, S., 1977. The determination of financial structure: The incentive signaling
approach'. Bell Journal of Economics, 8, pp. 23-40.
[69] Ross, S.A., Westerfield, R.W. and Jaffe, J., 2005. Corporate Finance. New York: McGraw-
Hill Companies.
[70] Sarlija, N. and Harc, M., 2009. The impact of liquidity on the capital structure: a case
study of Croatian firms. Business System Research, 3(1), pp. 30-36.
[71] Saunders, M., Lewis, P. and Thornhill, A., 2009. Research methods for business students.
5th ed. Harlow: Pearson Education Limited.
[72] Sharma, A.K., 2005. Text book of correlation and regression. New Delhi: Discovery
Publishing House.
[73] Simerly, R. and Li, M., 2000. Environmental dynamism, financial leverage and
performance: a theoretical integration and an empirical test. Strategic Management
Journal, 21, pp. 31-49.

Page 16
[74] Sogorb ,F. and Lopez, J., 2003. Pecking order versus trade-off: An empirical approach to
the small and medium enterprise capital structure. Instituto Valenciano De
Investigaciones Econmicas, S.A., working paper.
[75] Titman, S., 1984. The effect of capital structure on a firm's liquidation decisions. Journal
of Financial Economics, 13, pp. 137-151.
[76] Walsh, E.J. and Ryan, J., 1997. Agency and Tax Explanations of Security Issuance
Decisions. Journal of Business Finance and Accounting, 24 (7), pp.94159.
[77] Weston, J. F., & Copeland, T. E., 1986. Managerial finance. 8th ed. Chicago: Dryden Press.
[78] Williams, C., 2007. Research Methods. Journal of Business and Economic Research, 5 (3),
pp. 65 - 72.
[79] Wolff, J.A. and Pett, T.L., 2006. Small-firm Performance: Modeling The Role of Product
and Process Improvements. Journal of Small Business Management, 44 (2), pp. 268-84.
[80] Yasmin, S. and Yusuf, M.A., 2008. Market capitalisation - Concept, measurement and
significance [pdf] Available at:
http://www.icmab.org.bd/index.php?option=com_docman&task=doc_download&gid=1
11 [Accessed 2 May 2014].
[81] Yee, J.L. and Niemeier, D., 1996. Advantages and disadvantages: Longitudinal and
Repeated cross-section survey [pdf] Available at:
http://ntl.bts.gov/data/letter_am/bat.pdf [Accessed 18 April 2014].
[82] Zhang, H. and Li, S., 2008. The impact of capital structure on agency cost: Evidence from
UK Public Companies [pdf] Available at:
http://www.pbfeam2008.bus.qut.edu.au/papers/documents/HeZhang_Final.pdf
[Accessed 16 April 2014].
[83] Zwiebel, J., 1996. Dynamic capital structure under managerial entrenchment. American
Economic Review, 86, pp. 1197215.

Page 17