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This research investigated the relationship between capital structure and
profitability of eight companies working in the basic material sector in Saudi
Arabia during the period 2009 to 2018. The statistical techniques used are regression
analysis, fixed effect model, random effect model, and Hausman test.
The dependent variable is the return on equity (*ROE*). In contrast, independent
variables are a short-term debt to total assets ratio (*SDA*), long-term
debt to total assets ratio (*LDA*), and total debt to total assets ratio (*DA*). The
results illustrate a negative relationship between short-term debt to total assets
ratio (*SDA*) and profitability and this complement with studies like Hamid
and others (2015) [1] and Abeywardhana (2015) [2], a negative relationship
between long-term debt (*LDA*) and profitability which complement with
studies like El-Sayed Ebaid (2009) [3], and positive relationship between total
debt (*DA*) and profitability which complement with studies like Abor (2005)
[4], Hamid and others (2015).

The capital structure is the mix of the external fund and internal fund that a firms use in its major operation and varieties of securities. For example, lease financing to acquisition on new assets, and issue bonds. Firms can also issue new common stocks or preferred stocks to maximize shares in the market and enter new projects (Abor, 2005). The capital structure will raise the agency cost between the shareholders and managers, and thus between debt holders and equity holders (Jensen and Meckling, 1976) [

The component of financial leverage used in this study is short-term debt to total assets, long-term debt to total assets, and total debt to total assets. Studies illustrate a positive relationship between leverage level and firm profitability (Taub, 1975; Roden and Lewellen, 1995; Ghosh et al., 2000; Hadlock and James, 2002) [^{1}. 42 public companies worked in producing cement, oil, glasses, plastic, chemicals and metals and several sectors have been merged with petrochemicals to become the largest. The objective of the study is to investigate the relationship between capital structure and profitability of the firm in the basic materials sectors in Saudi Arabia during the period 2009 to 2018.

The scope of the study is eight firms of the basic material sector: Saudi Basic Industries Co. (SABIC), Zamil Industrial Investment Co. (ZIIC), Saudi Kayan Petrochemical Co. (KAYAN), Saudi Arabian Mining Co. (MAADEN), Yanbu National Petrochemical Co. (YANSAB), Sahara International Petrochemical Co. (SIPCHEM), Saudi Steel Pipe Co. (SSP) and Saudi Industrial Investment Co. (SIIG). The main goal of any company is to maximize shareholder wealth by increasing net profit. Furthermore every kind of fund either external or internal has a cost, so the manager should determine the optimal option of fund, especially in the environment that fever of competences is high. Thus, the results of this study are helping the managers in the firms to make the right decisions to use the optimal amount of internal and external funds to increase profitability.

Research questions

This research aims to answer the following questions:

1) What are the relationships between short-term debt to total assets ratio and return on equity?

2) What are the relationships between long-term debt to total assets ratio and return on equity?

3) What are the relationships between total debt to total assets ratio and return on equity?

In this study, 20 scientific papers were published on the relationship between the capital structure and the profitability of companies in several different countries in which the authors used several dependent and independent variables in addition to different statistical techniques to obtain whether there is a positive or negative relationship or there is no relationship between the capital structure And profitability. The results of each scientific paper were also linked to each other, in addition to the gaps in each study and their effect on the extracted results were presented.

Mesquita and Lara (2003) [

Abor (2005) criticizes the impact of capital structure on profitability on listed firms of the Ghana Exchange (GSE) for five years. The dependent variable used in this study is Return on equity (ROE), while independent variables are Short-term debt to total assets (SDA), Long-term debt to total assets (LDA), and Total debt to total assets (DA). The statistical technique used is regression analysis. The results illustrate that significant positive relationship between the ratio of short-term debt to total assets (SDA) and profitability, a negative relationship between the ratio of long-term debt to total assets (LDA) and profitability and a significantly positive association between the ratio of total debt (DA) to total assets and profitability. The results indicate that the increase in short-term debt and total debt is causing to raise profitability, but on the otherwise increasing in long-term debt will reduce profitability. The author relied on a single statistical technique in his analysis of the data, which would weaken the data, in addition to the fact that the study was in an emerging country, in which the extracted data is biased or inaccurate, which would make the data useless.

Salawu and Awolowo (2007) examine the effect of capital structure on profitability from the listed company in Nigeria secondary data from 1990 to 2004. The dependent variable is earnings before interest and tax to the book value of total assets, correspondingly the independent variables is Total liabilities ratio, Long-term liabilities ratio, and Short-term liabilities ratio. The statistical techniques used for analysis are The Pooled Ordinary Least Squares (OLS) model, Fixed Effect Model (FEM), and Random Effect Model (REM), and the estimation model used is panel data. The results illustrate a positive correlation between profitability and short-term debt and equity but the inverse correlation with long-term debt; the results also demonstrate a negative association between the ratio of total debt to total assets (LEV1) and profitability. The study was conducted in an emerging country, and the data used may be inaccurate, in addition to that the author relied on the book value of the assets and not the market value. Therefore, this data cannot be applied on the ground or used for forecasting.

Ebaid (2009) explores the impact of capital structure on firm performance in Egypt. The data used is a non-financial Egyptian listed firm from 1997 to 2005. The dependent variables are Return on equity (ROE), Return on assets (ROA), and Gross profit margin (GM). On the other hand, the independent variable was incorporate Short-term debt to assets (STD), Long-term debt to assets (LTD), and Total debt to assets (TTD). The statistical technique used is multiple regression analysis. The dependents variables have a significant negative relationship with independent variables. The author used one technique for additional analysis, which would weaken the data in addition to the fact that the study was in an emerging country and not a member of any international organization that obliges it to publish reports and data periodically, so the data used may be biased. The country is also located in a hot geographical and political area which what happens around its borders may affect its economy

Azhagaiah and Gavoury (2011) try to prove there is a relationship between capital structure and profitability on a list of 201 information technology firms in the Bombay Stock Exchange in India through the period 1999 to 2007. The dependent variables are the return on assets (ROA) and return on capital employed (ROCE), while independent variables are a total debt to total assets ratio (TD_TA), the expense to income ratio (EXP_INC), debt-equity ratio (DER) and current ratio (CR). The statistical technique used is Regression analysis. The results show a negative relationship between total debt to total assets ratio, the expense to income ratio, debt to equity ratio, and current ratio with profitability. The author used one statistical technique which may lead to inaccurate data.

Gill et al. (2011) [

San and Heng (2011) [

Soumadi and Hayajneh (2012) [

Salim and Yadav (2012) [

Velnampy and Niresh (2012) [

Addae et al. (2013) [

Ahmad (2014) [

Tailab (2014) [

Yegon et al. (2014) [

Hamid et al. (2015) investigate the impact of capital structure on the profitability of 46 family and non-family firms in Malaysia during the period 2009 to 2011. The dependent variable is the return on equity (ROE), while independent variables in this examine are a short-term debt to total assets ratio (SDA), long-term debt to total assets ratio (LDA), and total debt to total assets (TDA). The statistical techniques using in this study are the Mann-Whitney U Test, Correlation matrix, and Multivariate analysis. The results illustrate a negative relationship between short-term debt ratio, long-term debt ratio, and total debt ratio with profitability. The study was in an emerging country, in addition to that, the study period was short and the dependent variable used is only one, which weakens the extracted data.

Abeywardhana (2015) studied the impact of capital structure on the profitability of non-financial SMEs firms in the UK during the period from 1998 to 2008. The dependent variables are the return on assets ratio (ROA) and return on the capital-employed ratio (ROCE) while independent variables are a debt to equity (GERINGR), total debt to total assets (TD), long-term debt to total assets (LTD), short-term debt to total assets (STD) and short-term debt to total debt (STDTD). The statistical technique used is Two-Stage Least Squares (2SLS). The results are illustrate a negative relationship between capital structure ratios and performance ratios. The study was on small and medium-sized companies, which the extracted results may not be useful to track for large and giant companies, in addition to that the author relied only on one holding technique, which would weaken the extracted data.

Movalia (2015) [

Semuel and Widjojo (2016) [

Anrfo and Appiahene (2017) [

Singh and Singh (2016) [

For the summery of the results and form the long-term perspective, the study by San and Heng (2011) shows a positive relationship with profitability, and this study complements the study by Gill et al. (2011). Other studies illustrate negative relationship like Ebaid (2009) and Salawu and Awolowo (2007) and Abor (2005) and Addea et al. (2013) and Mesquita and Lara (2003) Salim and Yadav (2012) Yegon et al. (2014) and Hamid and others (2015) and Abeywardhana (2015) and Ahmad (2014).

From the short-term debt perspective the study by Salawu and Awolowo (2007) showing a positive relationship with profitability and this study complement with the study by Abor (2005) and Addea et al. (2013) Mesquita and Lara (2003) and Ebaid (2009) and Salim and Yadav (2012) and Yegon et al. (2014) Gill et al. (2011) and Tailab (2014) and Ahmad (2014). Other studies illustrate negative relationships like Hamid et al. (2015) and Abeywardhana (2015).

From the total debt perspective, the study by Abor (2005) shows a positive relationship with profitability and this study complement with the study by Hamid et al. (2015) and San and Heng (2011) and Gill et al. (2011) and Movalia (2015). Other studies illustrate negative relationship like Ebaid (2009) and Salawu and Awolowo (2007) and Soumadi and Hayajneh (2012) and Addea et al. (2013) and Salim and Yadav (2012) and Tailab (2014) and Azhagaiah and Gavoury (2011) and Abeywardhana (2015) and Ahmad (2014). Other studies illustrate no effecting like Yegon et al. (2014) and Anrfo and Appiahene (2017) and Singh and Singh (2016).

Type of Study

The study covers the period from 2009 to 2018 using cross-sectional data by Bloomberg terminal, https://www.bloomberg.com/europe.

The Model

The following regression models are estimated: (Abor 2005), (Gill, et al., 2011).

R O E i t = β 0 + β 1 D A i t + β 2 L D A i t + β 3 D A i t + β 4 S i z e i t + β 5 S G i t + e 3

where:

β0: The intercept of the equation.

β: Coefficients for independent variables.

ROE: Net Income/average equity.

SDA: Short-term debt/total assets.

LDA: Long-term debt/total assets.

DA: Total debt/total assets.

Size: Natural Logarithm of the firm’s sales, lagged one-year period.

SG: Current year’s sales minus the previous year’s sales divided by the previous year’s sales.

i: firm.

t: time = 1, 2, …,10 years.

eit = Error term.

Statistical Analysis Techniques

1) Regression Analysis: used to investigate the relationship between capital structure and profitability measured by ROE.

2) Fixed Effect Model: regression model in which the group means are fixed (non-random).

3) Random Effect Model: used in panel analysis of hierarchical or panel data when one assumes no fixed effects (it allows for individual effects).

4) Hausman Test: (Hausman 1978) are tests for econometric model misspecification based on a comparison of two different estimators of the model parameters.

5) Pearson Correlation: used to identify the direction to statistical relationships between independent variables and the dependent variables.

Hypotheses and Conceptual Framework

H01: There is a positive relationship of short-term debt on total assets and profitability.

H02: There is a positive relationship of long-term debt on total assets and profitability.

H03: There is a positive relationship of total debt on total assets and profitability.

Data Collection Method

The cross-sectional data. Extract data from Bloomberg website from 2009-2018.

Population and Study Sample

All basic materials shareholding companies that satisfy the following conditions will incorporate in the study sample:

1) Share price data are available during the study period (2009-2018), and there is an availability of data required to calculate study variables.

2) The company did not enter in a consolidation process or allocated free shares because these events affect the company figures such as earnings.

Descriptive Statistics

The variable SDA measures the ratio of short debt to total assets, and the average value of this variable is 8.45 percent, with a median of 4.2 percent. This value indicates that short-term debts represent approximately 8.45 percent of total assets. The variable LDA measures the ratio of long-term debt to total assets. The average value of this variable is 32.07 percent, with a median of 36.17 percent, in which this value indicates that long-term debts represent approximately 32.07 percent of total assets. That proves that Saudi firms in the basic material sector depend on long-term funding their operations compared with short-term debts.

ROE | SDA | LDA | DA | Size | SG | |
---|---|---|---|---|---|---|

Mean | 8.36813 | 8.4525 | 32.079 | 40.606 | 8.409 | 1.36 |

Standard Error | 0.97575 | 1.34917 | 2.2564 | 1.8915 | 0.25302 | 0.61 |

Median | 8.74 | 4.2 | 36.17 | 45.005 | 8.605 | 0.36 |

Mode | 14.2 | 0 | 0 | 0 | 12.15 | 0 |

Standard Deviation | 8.7274 | 12.0673 | 20.182 | 16.918 | 2.263077 | 5.43 |

Sample Variance | 76.1674 | 145.62 | 407.31 | 286.23 | 5.121518 | 29.5 |

Kurtosis | 2.90347 | 3.61063 | −1.404 | −0.359 | 5.648078 | 7.45 |

Skewness | −0.4959 | 2.19621 | −0.14 | −0.617 | −1.57483 | 1.01 |

Range | 61.72 | 46.3 | 64.83 | 69.17 | 12.15 | 44 |

Minimum | −26.16 | 0 | 0 | 0 | 0 | −20 |

Maximum | 35.56 | 46.3 | 64.83 | 69.17 | 12.15 | 24.3 |

Sum | 669.45 | 676.2 | 2566.3 | 3248.5 | 672.72 | 109 |

Count | 80 | 80 | 80 | 80 | 80 | 80 |

Confidence Level (95.0%) | 1.94219 | 2.68545 | 4.4913 | 3.765 | 0.503623 | 1.21 |

The variable DA measures the ratio of total debt to total assets. The average value of this variable is 40.60 percent, with a median of 45 percent, which illustrates that the companies have financial leverage with a large percentage of total debt being long-term. The average sales growth is 1.36 percent, and the average firm size measured by logarithm of sales, lagged by one year, came to 8.409.

Correlation Coefficient

Regression Analysis

ROE | SDA | LDA | DA | Size | SG | |
---|---|---|---|---|---|---|

ROE | 1 | |||||

SDA | 0.0640636 | 1 | ||||

LDA | −0.2479924 | −0.551204 | 1 | |||

DA | −0.248687 | 0.0532543 | 0.803301 | 1 | ||

Size | 0.3875937 | 0.0286031 | −0.163842 | −0.175377 | 1 | |

SG | 0.0327496 | −0.133294 | 0.203707 | 0.165036 | 0.075746 | 1 |

Variable | Coefficient | Std. Error | t-Statistic | Prob. |
---|---|---|---|---|

C | 0.700446 | 4.546921 | 0.154048 | 0.8780 |

SDA | −0.811152 | 1.714488 | −0.473116 | 0.6375 |

LDA | −0.862960 | 1.713252 | −0.503697 | 0.6160 |

DA | 0.759333 | 1.712989 | 0.443280 | 0.6589 |

SG | 0.032750 | 0.195697 | 0.167349 | 0.8676 |

Size | 1.347150 | 0.412525 | 3.265624 | 0.0017 |

Variable | Coefficient | Std. Error | t-Statistic | Prob. |
---|---|---|---|---|

C | 14.21439 | 2.543705 | 5.588065 | 0.0000 |

SDA | −0.516768 | 1.664217 | −0.310518 | 0.7571 |

LDA | −0.599432 | 1.668703 | −0.359220 | 0.7206 |

DA | 0.437141 | 1.664172 | 0.262678 | 0.7936 |

Variable | Coefficient | Std. Error | t-Statistic | Prob. |
---|---|---|---|---|

C | 13.24424 | 2.519425 | 5.256852 | 0.0000 |

SDA | −0.998127 | 1.570299 | −0.635629 | 0.5269 |

LDA | −1.058185 | 1.574266 | −0.672177 | 0.5035 |

DA | 0.923643 | 1.569128 | 0.588634 | 0.5579 |

Test Summary | Chi-Sq. Statistic | Chi-Sq. d.f. | Prob. |
---|---|---|---|

Cross-section random | 7.973669 | 3 | 0.0466 |

No | Hypotheses | Null |
---|---|---|

H01 | There is a positive effect of short-term debt on total assets and profitability. | Reject |

H02 | There is a positive effect of long-term debt on total assets and profitability. | Reject |

H03 | There is a positive effect of total debt on total assets and profitability. | Accept |

The capital structure is a crucial tool to fund the prospect projects by mixing of internal fund (equity) and external fund (debt), to describe capital structure through calculating the ratio of equity and the ratio of debts to total capital paid, can also be described by the leverage ratio. Capital structure has direct correlated with average cost of capital and it is one elements of firms’ valuation if the capital structure changes the average will change which leads to change in the value of firm.

This study, investigates the relationship between the capital structure and profitability on the eight firms, which are Saudi Basic Industries Co. (SABIC), Zamil Industrial Investment Co. (ZIIC), Saudi Kayan Petrochemical Co. (KAYAN), Saudi Arabian Mining Co. (MAADEN), Yanbu National Petrochemical Co. (YANSAB), Sahara International Petrochemical Co. (SIPCHEM), Saudi Steel Pipe Co. (SSP) and Saudi Industrial Investment Co. (SIIG) which operate in the basic materials sector in Saudi Arabia during the period from 2009 to 2018. The dependent variable is return on equity (ROE), while the independent variables are the ratio of short-term debt to total assets (SDA), the ratio of long-term debt to total assets (LDA), and the ratio of total debt to total assets (DA). The results illustrate a negative relationship between short-term debt to total assets ratio (SDA) and return in equity ratio (ROE), and this complements with studies like Hamid and others (2015) and Abeywardhana (2015). A negative relationship is between long-term debt to total assets ratio (LDA) and return in equity ratio (ROE), and this complements with studies like El-Sayed Ebaid (2009) and Salawu and Awolowo (2007). And positive relationship is between total debts to total assets ratio (DA) and return in equity ratio (ROE), and this complements with studies like Abor (2005) and Hamid and others (2015). According to correlation model, the results illustrate a positive relationship between short-term debt to total assets ratio (SDA) and return on equity ratio (ROE) 6%, a positive relationship between long-term debt to total assets ratio (LDA) and return on equity ratio (ROE) 25%, and a negative relationship between total debt to total assets ratio (DA) and return on equity ratio (ROE) −25%. In contrast, the control variables show a positive relationship between the size of firm (SIZE) and return on equity ratio (ROE) 29%, and a positive relationship between the percentage change in sales (SG) and return on equity (ROE) 3%. The relying on one source of debt either short-term debt or long-term debt will decrease the profitability and make the investment in the firms less incentives. In contrast, the managers of firms that take decide to mix between the short-term debt and long-term debt will lead to increase the profitability and make the firms more liquidity and solvency to meet his current liabilities and non-current liabilities. Furthermore making firms attractive to flow the monies from investors leads to expand the operations and grow and maximize the wealth of shareholders. According to Hausman Test, it is shown that probability value is less than 5%, which means rejecting the null hypothesis and accepting alternative hypothesis so the fixed effect model is the appropriate mode. An explanation of covariance is that the values of the short and long-term debt ratios to total assets are negative −56 and −60 respectively, indicating that these two variables cause a decrease in profitability; on the contrary, the ratio of total debt to total assets showed a positive value, which indicates that the total short and long-term debts combined are not alone; they will increase profitability.

The recommends:

1) The firms must use both of short-term debt and long-term debt to fund their operations and increasing profitability.

2) The study is limited to the sample of eight Saudi Arabia basic materials sector. Future research should increase the sample and investigation of multiple sectors.

The author declares no conflicts of interest regarding the publication of this paper.

Hajisaaid, A.M.S.A. (2020) The Effect of Capital Structure on Profitability of Basic Materials Saudi Arabia Firms. Journal of Mathematical Finance, 10, 631-647. https://doi.org/10.4236/jmf.2020.104037