Financial leverage and firm performance evidence from Amman stock exchange.

Author:Abu-Abbas, Bassam M.
 
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  1. Introduction

    Studying the relationship between financial leverage and firm performance has contradictory results. Some researchers argue that the differences in the results may due to the differences in the approaches used in analyses (e.g., O'Brien 2003). A few previous studies (e.g., King and Santor 2008, and Philips and Sipahioglu 2004) have examined the direct relationship between financial leverage and firm performance while others (e.g. Jermias 2008) have examined the relative influence of the competitive intensity and business strategy on the relationship between financial leverage and firm performance.

    Modigliani and Miller (1958) suggest that financial leverage is irrelevant to firm performance. Some studies (e.g., Jensen and Meckling 1976, Brander and Lewis 1986, Grossman and Hart 1983, and Jensen 1986) suggest a positive relationship between financial leverage and firm performance. On the other hand, other studies (e.g., Myers 1977, Maksimovic and Titman 1991, and Titman 1984) suggest a negative relationship.

    Using panel data consisting of 56 manufacturing firms from the Amman Stock Exchange during the period between 2011 to 2014, the study tries to answer the following three questions. First, does financial leverage have a negative relationship with firm performance in developing countries like Jordan? Second, will this relationship be more negative for the firms that use product differentiation strategy compared with the firms that use the low-cost strategy? Finally, will this relationship be more negative for the firms with high degrees of competitiveness compared with the firms with a low degree of competitiveness?

    This study examines the effect of financial leverage on firm performance using two different approaches of analyses, namely, the direct relationship between financial leverage and firm performance and the relative influence of competitiveness and business strategy on the relationship between financial leverage and firm performance.

    The study contributes to the literature by trying to solve the puzzle in the mixed results and test whether using different approaches have an effect on the results of studying the relationship between financial leverage and firm performance. Evidence on the relationship between financial leverage, firm performance, competition and business strategy is generally limited, especially in developing countries. This work may help in filling the gap. In addition, this work may have a few implications for practitioners and management. The study uses two dependent variables (ROA and EVA) as proxies for firm performance. In addition, it uses two control variables (EMP and FA) to control the value chain risk. This is considered very important and neglected by a number of authors in the literature.

    It is important to say that the study has a few limitations that may affect its results. We use data from only the manufacturing industry due to the limited availability of data required for the analyses in other industries in the Amman Stock Exchange. In addition, Parthiban et al. (2008) suggest that the type of debt (bank debt or bond debt) may affect the relationship between competitiveness and performance. Information related to breaking down the debt to bank debt, bond debt and other debt is not available. Finally, other variables may have some affects between the relationship between the leverage and firm performance, such as, the economic and political conditions such as the Arab Spring and the sharp drop in the oil prices during the study period. Excluding these variables may influence the results.

    The remainder of the paper is organized as follows. Section 2 introduces the literature review. Section 3 describes the research methodology and hypotheses. Section 4 presents the data analyses and empirical results. Finally, section 5 summarizes and concludes the results.

  2. Literature Review

    2.1. The Trade-Off Theory

    The original version of the trade-off theory grew out of the debate over Modigliani-Miller (Frank and Goyal, 2011). The trade-off theory suggests that firms choose how much to finance with debt or equity by balancing their costs and benefits (Muritala, 2012). Mohamad and Abdullah (2012) argue that the trade-off theory implies that financial leverage has a positive relationship with the firms' performance. Trade-off theory considers the cost of bankruptcy associated with debt financing as well as the tax advantage.

    The theory explains how the corporations usually distribute its finance partially between debt and equity. The advantage of debt financing is the tax benefit of debt, while the disadvantages are represented by both the bankruptcy and non-bankruptcy costs of debt. According to the trade-off theory, the decision makers in the corporations evaluate the various costs and benefits of alternative leverage plans to determine their level debt financing by trading off the cost and the benefit of debt.

    2.2. Direct relationship between financial leverage and firm performance

    The impact of financial leverage and performance has been the major focus of many studies (e.g., Jensen and Meckling 1976, Brander and Lewis 1986, Grossman and Hart 1983, Jensen 1986, Myers 1977, Maksimovic and Titman 1991, and Titman 1984). The famous influential paper by Modigliani and Miller (1958) developed different theoretical predictions to build a solid foundation of the relationship between financial leverage and firm value. The previous studies' results remain unclear in determining this relationship.

    For example, Fama and French (2002); Gill et al. (2011); Ramachandran and Candasamy (2011); Wang (2003); Goyal (2013); Saeed, et al. (2013); Nawaz et al. (2011); and David and Olorunfemi (2010) find a positive relationship between leverage and profitability.

    On the other hand, Pouraghajan and Malekian (2012); Olokoyo (2013); Quang and Xin (2014); Sheikh and Wang (2013); Mireku et al. (2014); Krishnan and Moyer (1997); King and Santor (2008); Muritala (2012); Babalola (2012); and Mohamad and Abdullah (2012) find a negative relationship between leverage and firm performance. Mouna et al. (2017) examine the relationship between capital structure and the firms' performance. The results show that debt ratio has a negative significant effect on the return on assets, debt equity ratio has a negative significant effect on return on equity, and size has a positive significant impact on firm performance using return on equity as proxy. Nisha and Ghosh (2018) examine the cause and effect relationship between leverage and the financial performance of firms. They find a negative relationship persists between leverage and performance. In addition, they find that there was no significant difference in the financial performance between high levered and low-levered firms, neither in their size nor in their growth rates. Akpinar and Yigit (2016) examine the difference between the types of diversification and performance comparing Turkey, Italy and Netherlands. They find no correlation between the types of diversification and performance in both Italy and Netherlands, while there is a low-level of positive correlation in Turkey. This means that the results may differ by country.

    Modigliani and Miller (1958) expect that the capital structure of a firm is irrelevant to its performance. However, capital structure affects the tax-deductibility of debt interest and agency theory. Abubaker (2015) investigates the relationship between financial leverage and financial performance of the deposit money banks in Nigeria. The findings indicate that there is no significant relationship between the debt ratio and financial performance surrogated by ROE. Myers (1997) expects that the leverage may affect the investment and reduce the market value of the firm. Titman (1984) argues that leverage affects the likelihood of a firm's liquidation. Maksimovic and Titman (1991) suggest that a high level of leverage has a negative effect on firm performance. Philips and Sipahioglu (2004) report insignificant results between financial leverage and firm performance. Muritala (2012) examines the optimum level of capital structure through which a firm can increase its financial performance. The author expects a negative relationship between capital structure and operational firm performance. He finds that asset turnover, size, the firm's age and the firm's asset tangibility are positively related to the firm's performance. Lawal et al. (2018) examine the effect of ownership structure on financial performance. Ownership structure proxies by managerial ownership, institutional ownership, and ownership concentration are adopted as independent variables. The study finds ownership structure to have a significant positive effect on financial performance when it is proxies as managerial ownership and institutional ownership while having a significant negative effect when it is proxies as ownership concentration. However, in respect of the size and growth of the firms, which form the control variables of the study, there are mixed evidences of their effects on financial performance. Khamis et al. (2015) assess the relationship between ownership structure dimensions and corporate performance. They find that ownership concentration has a negative relationship on a company's performance while managerial ownership and institutional ownership have a positive relationship on a company's performance.

    Based on previous literature, empirical conclusions have mixed results. Some report a negative relationship while others report positive or insignificant effects. Some studies suggest that the relationship between the leverage and performance is conditional on the degree of agency problem associated with firms. For example, Schoubben and Van Hulle (2004) show that leverage has a positive effect on quoted firms but a negative on non-quoted firms. Ruland and Zhou (2005) find that leverage improves the performance of diversified...

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