Relationship Between Capital Structure And Profitability : A Time-Series Cross-Sectional Study On Malaysian Firms

Ever since the M&M Propositions were made in 1958, the issue of capital structure has gained much interest and controversy. The propositions which contended that the value of a firm is independent of its capital structure, have been put to test and researched into time and again. Most of the studies, however, were done in the U.S., hence doubts arise on whether the conclusions would apply in the Malaysian context. Based on this motivation, this study attempted to solve the dearth of research on capital structure, particularly its effect on profitability, of local firms. A total of 267 firms listed on the Kuala Lumpur Stock Exchange Main Board were put under study for a period of ten years (1985 - 1994). Two major sets of variables were used to indicate capital structure i.e. Debt/Equity Ratio, Debt Ratio, Financial Leverage Ratio, Funded Capital Ratio, Funded Debt Ratio, Current Debt Ratio, Funded Assets Ratio, and, profitability i.e. Return On Equity, Earnings Per Share, Return On Investment, Profit Before Tax, Net Income. The variables were analyzed using the time-series cross-sectional methodology. In order to generate empirical evidence, the Pearson Product-Moment Correlation, mean and bar chart analysis were employed. The results implied that profitability is significantly related to capital structure. Specifically, profitability was inversely related to the amount of liability in a company’s capital structure. Therefore, the more debt a firm incur, the worse its earnings is hurt. This study also found evidence of the existence an optimal capital structure among listed companies. Firms of different sectors were found to adjust their capital structure regularly in order to achieve an optimal combination of debt and equity