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| Impact of Capital Structure and Financial Liquidity on Corporate Profitability: A Case Study of Selected Financial Institutions Listed in India | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Paper Id :
16764 Submission Date :
2022-11-07 Acceptance Date :
2022-11-07 Publication Date :
2022-11-15
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| Abstract |
The study asserts that the capital structure and financial liquidity plays an important role in improving profitability of financial institutions. Hence, this study attempts to investigate the gray areas in the impact of these variables on the profitability of selected financial institutions.Data was compiled from the audited financial statements of selected financial institutions (Axis Bank, HDFC Bank, ICICI Bank, Kotak Mahindra Bank, and State Bank of India) for a period of five years from 2017-18 to 2021-22.The data was analyzed using statistical techniques - correlation and regression, to know the relationship between study variables and the impact of independent variables on dependent variables. Taking current ratio as a proxy of financial liquidity, debt-equity ratio and total debt ratio as proxies of capital structure, the study analyzed the profitability of the selected financial institutions from two perspectives – return on assets and return on equity. The study concluded that the financial liquidity has a significantly positive impact on corporate profitability while the capital structure has a significantly negative impact on corporate profitability.
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| Keywords | Capital Structure, Financial Liquidity, Corporate Profitability, Financial Performance, Financial Institutions. | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Introduction |
1.1 Research Background
The capital structure of an enterprise simply reflects the efficiency with which it utilizes its assets through various financing options - Debt (in the form of borrowings), equity (by issuing shares), and personal savings (for small businesses). The capital structure generally refers to the mix of equity and long-term liabilities. In general, companies with higher debt financing are considered riskier, although some analysts believe that capital structure is not critical to risk or profitability (Zeb et al., 2016).
As also, liquidity plays an important role in improving business performance. Financial liquidity is the ability of an enterprise to meet immediate and short-term obligations through holding cash or a portfolio of assets that can be quickly converted or realized into cash (Daryanto et al., 2018). Its high level allows continuity of trading activities with minimal price disruption.The measurement of financial liquidity provides very helpful information to internal and external investors regarding the functioning and the level of profitability (Zygmunt, 2013).
Every profit-seeking enterprise wants to generate good returns and increase its market value so that investors can recover their investment and this gives a positive signal to the market (Bhatnagar et al., 2019). Thus, the basic goal of every company is to maximize its profitability as well as employ an optimum capital structure and maintain an appropriate level of financial liquidity.Though the profitability of enterprises varies depending on the size and level of their commercial activities, profitability is the base to assess their success.
Moreover, financial institutions view debt financing from a different perspective as they rely on financing from short-term and long-term debts. Financial and banking institutions have always mobilized different types of deposits into their pools from which they allocate funds for loans and financing and other income-generating assets present in their portfolios. Profitable management of these short-term and long-term debts becomes a central issue for financial institutions.
However, a large body of research has focused on individual predictors of profitability, such as capital structure (Dinh& Pham, 2020), financial leverage (Afolabi, 2019; Rahman et al., 2020), organizational size (Marfuah&Nurlaela, 2019), liquidity (Rahman & Sharma, 2020), interest coverage (Gul & Cho, 2019), and so on. Taking a broader perspective, this articleattempts to analyze the impact of different explanatory variables of capital structure and financial liquidity on the various profitability measures of listed financial institutions in India, which is the central issue of current research.
1.2 Statement of the Problem
The combined impact of financial liquidity and capital structure variables on organizational financial performance has always been a major concern for financial managers of enterprises in different sectors. These variables must be properly combined to improve organizational financial performance. Against this backdrop, this study attempts to identify the gray areas in the impact of these variables on the profitability of selected financial institutions.
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| Objective of study | 1. To analyze and describe the capital structure and financial liquidity practices employed by financial institutions in India for the period 2017-18 to 2021-22.
2. To study the impact of capital structure and financial liquidity on the profitability of listed financial institutions in India.
Scope of the study-
The scope of the present study is underlined as below -
1. The study is based on listed companies in India.
2. The study is limited to only banking and finance industry.
3. The study is based on the financial data of last 5 years only.
Rationale of the Research-
The need for this study can be justified on the basis of the following facts:
1. It will improve the quality of the extant literature on organizational liquidity and capital structure.
2. It will provide knowledge to practitioners and academics interested in the fundamental practices of financial liquidity and capital structure.
3. Based on the study outcomes, it will provide financial managers with some recommendations to incorporate elements of the variables studied and the best way to combine these variables to support increased profitability. |
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| Review of Literature | Review of Background Theories Trade-Off Theory The “Trade-off theory” was originally proposed by Krauss and Litzenberger (1973) and later developed by Myers and Mazlouf (1984). The theory originally suggested that the benefits of using debt could be zero or negative when a business is so inefficient that it becomes bankrupt. Whether or not an enterprise may become bankrupt depends on the operational risks of the enterprise as well as the capital sourcing, management, operating, and utilization policies of the enterprise. Krause and Litzenberger (1973) argued that “the optimal capital structure reflects a trade-off between the tax benefits of debt and the costs of bankruptcy.” The Pecking Order Theory The “Pecking order theory”suggests that companies follow a priority pattern for their capital structure choices, particularly when it comes to debt financing. Myers &Majluf (1984) propounded that the "pecking order" model is based on asymmetric information, as managers have intrinsic information about the company's future prospects and act in a way that benefits existing shareholders. Thus, companies prefer internal financing (utilizing retained earnings) in contrast to external financing, and in case external financing is needed, companies prefer debt over equity. Empirical tests of this theory have yielded mixed results, and it can be argued that the hypothesis on which this theory is based appears to be highly applicable to data before 1990 than after 1990 (Ni & Yu, 2008). Review of Empirical Research Studies Daryanto et al. (2018) examined the effect of capital structureand liquidity on the financial performance of three listed realestate companies from Indonesia over a five-year period (2012 to 2016). The results show that the liquidity and total debt ratio are negatively correlated with the return on assets (ROA). Gul and Cho (2019) asserted that a rise in the short-term debt-to-equity ratio leads to a higher default risk, while a rise in the long-term debt-to-equity ratio leads to a lower default risk. The study further shows that tangible assets, firm size, and interest coverage significantly determine default risk. Afolabi et al. (2019) used econometric models and regression analysis to study the impact of financial leverage and profitability of Nigerian firms. The results indicated a significant positive impact between financial leverage (DER and TDR) and profitability, suggesting that the firms should continue to use debt financing so as to benefit from the available tax shields and ultimately increase profits. Qayyum and Noreen (2019) conducted a study on conventional and Islamic banking institutions. The study found that ROE was positively correlated and ROA was negatively correlated with the capital structure of both kinds of banking institutions. Furthermore, the study observed that, apart from the firm size, the capital structures of both kinds of banking institutions were similar. Dao and Ta (2020) used a meta-analysis approach to study the association between financial leverage and the financial performance of business organizations. Research asserted that financial performance was negatively related to capital decisions, favoring the agency-cost trade-off model and pecking order theory. Rahman et al. (2020) used a sample of 22 listed textile companies in Bangladesh to analyze the effect of leverage on corporate profitability. A combination of OLS and GMM models was used to test this impact. The study uses ROE to measure corporate profitability. Both short-term and long-term debts are used as agents of financial leverage. The findings indicated a significantly negativeassociation between financial leverage ratios and corporate profitability. It recommended paying greater attention to raising funds internally to meet their own financing needs. |
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| Main Text |
Theoretical Framework The conceptual theoretical model associated with financial liquidity and capital structure to the profitability of the financial institutions is presented in Figure 1 below:
Fig.1 – Theoretical Framework for the Study Study Variables Based on the above conceptual theoretical model, the connotations of the study variables are clarified in Table-1 below: Table – 1: Study Variables Defined
Source: Author’s own elaboration |
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| Methodology | Population, Sampling, and Sources of Data
Population for the purpose of the current study consists of all financial institutions listed in Indian stock exchanges. The listed Indian banks and financial institutions constitute the sampling units.The sample comprises of the selected financial institutions - Axis Bank, HDFC Bank, ICICI Bank, Kotak Mahindra Bank, and State Bank of India. The study analyzes the impact of financial liquidity and capital structure on the profitability, taking data from the audited financial statements of selected financial institutions for a period of five years from 2017-18 to 2021-22. |
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| Tools Used | The data was analyzed using statistical techniques like correlation and regression to know the relationship between study variables and the impact of independent variables on dependent variables. Research Models The multiple regression modelsadopted for this study arementioned as under: ROAi,n = β0 + β1CRi,n + β2DERi,n+ β3TDRi,n+ ɛi,n (1) ROEi,n = β0 + β1CRi,n + β2DERi,n + β3TDRi,n + ɛi,n (2) Where, β0indicates the intercept, β1, β2, and β3 indicates the coefficient of independent variables, ɛdenotes the error term, and i, n indicates the observation for the ith financial institution for the nth time period. This study is based on the hypothesized relationship that ROA/ROE = f(CR, DER, TDR). |
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| Analysis |
Descriptive Analysis The results of the descriptive analysis are depicted in the table-2 below: Table – 2: Results of Descriptive Analysis
Source: SPSS Output Correlation Analysis The results of the correlation analysis are depicted in the table-3 below: Table – 3: Results of Correlation Analysis
*Significant at .05 level. Source: SPSS Output Table-3 evidences that current ratio, the proxy of financial liquidity, shows positive correlation with profitability. However, debt-equity ratio and total debt ratio, the proxies of capital structure show negative correlation with profitability. Regression Analysis Table – 4: Regression Model Summary
Source: SPSS Output As evidenced by table-4, the value of adjusted R2 is .412 under model-1 (ROA). This indicates that independent variables (CR, DER, and TDR) explain only 41.2% of the dependent variable (ROA). The remaining 58.8% is explained by other variables that are not depicted in the current study. Likewise, the value of adjusted R2 is .561 under model-2 (ROE). This indicates that independent variables (CR, DER, and TDR) explain only 56.1% of the dependent variable (ROE). The remaining 43.9% is explained by other variables that are not depicted in the current study. Asobserved in Daryanto et al. (2018), variance inflation factor (VIF)and tolerance value may be used to check the multi-collinearity, i.e. similarity between the independent variables. As the tolerance values are higher than .1 and VIF is lower than 10, there is no multi-collinearity in the regression models. Table – 5: Regression Results of Model 1 [Model 1: ROAi,n = β0 + β1CRi,n + β2DERi,n + β3TDRi,n + ɛi,n]
Source: SPSS Output Table – 6: Regression Results of Model 2
[Model 2: ROEi,n = β0 + β1CRi,n + β2DERi,n + β3TDRi,n + ɛi,n]
Source: SPSS Output From the regression results summarized in tables 5 & 6, it can be observed that all the proxies of independent variables, CR, DER, and TDR significantly influences both the proxies of dependent variables (p<.05). Thus, both the research hypotheses H01 and H02 stands rejected. This indicates that capital structure and financial liquidity significantly impacts corporate profitability of listed financial institutions in India. The results of this study are in line with that of Daryanto et al. (2018); Dinh& Pham (2020); Rasheed et al. (2022); Zeb et al. (2016). |
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| Findings | 1. The financial liquidity,represented by current ratio, has shown positive impact on the profitability of the financial institutions, it can be suggested that the higher level of cash and near to cash resources will make the organization perform better in term of its profitability. 2. As both the proxies of capital structure have shown negative impact on the profitability of the financial institutions, it can be suggested that the mix of debt and equity in the capital structure of an enterprise should be wisely used by its financial manager, to ensure that such a combination helps the organization in fulfilling its goal of profit maximization. | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Conclusion |
This study was carried out to analyze the impact of financial liquidity and capital structure on the profitability of listed financial institutions in India. Five listed financial institutions (Axis Bank, HDFC Bank, ICICI Bank, Kotak Mahindra Bank,and State Bank of India) were selected and relevant data was compiled from their audited financial statements for a period of five years from 2017-18 to 2021-22. Taking current ratio as a proxy of financial liquidity, debt-equity ratio and total debt ratio as proxies of capital structure, the study analyzed the profitability of the selected financial institutions from two perspectives – return on assets and return on equity. Using multiple regression models, the study concluded that the financial liquidity has a significantly positive impact on corporate profitability while the capital structure has a significantly negative impact on corporate profitability. |
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| Suggestions for the future Study | This study has a major limitation that might give direction for further research studies in the future. The research framework adopted for the current study has yet to explain the antecedents of change in corporate profitability. Therefore, future researchers may consider incorporating some control variables to the model to explain the change in corporate profitability,as for example firm size, revenue growth, changes in government economic policies, growth rate of the economy, etc. Additionally, the research framework adopted for the current study for financial institutions might also be applied to other sectors. | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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