2.

0 Literature Review

Based on the review of previous researches there are many researches which intend
to find the relationship between financial structure & firm’s performance. There is a lot of
empirical evidence some researches have found positive & negative effect of financial
structure on firms’ performance (Muhammad, Bahadur , & Zia , 2014).

Various researches are done on financial structure & research scholars have
addressed about financing as it’s an integral part of business in present world, a lot of
research scholars have done different researches on the impact of financial structure on
firm’s performance by changing the industrial sectors in different countries and in different
regions. In previous researches firms performances are measured by accounting techniques
such as return on equity, return on asset, gross profit margins, net profit margin these
variables are used as dependent variables. However, to measure the impact of capital
structure there are many ratios used like debt to equity ratio, debt to asset ratio, financial
leverage ratios as independent variables and it has been found through different researches
that there is positive relation present between performance and growth of the firm with
respect to financial structure (Salim & Dr.Raj Yadav, December 2012).

It was identified by Ross & Jaffe.J, (1999) that to expand the overall worth of firm
management personnel’s should do efforts to expand the market worth and share of both
money debt & equity. An inadequate mixing of these two options of financing can increase
the charges of cost obtaining from these sources of finance (Ross & Jaffe.J, 1999).

Recent work has helped management personnel’s to determine the mix of debt and
equity and because of optimal mix many firms have expanded their performance. Contrary
to this many researchers have investigated that many firms are not using the mix approach
of debt and equity (Simerly & Mingfang, January 2000).

Financial managers always face the issues while making the decision on equity or
debt or both financing to polish up debt-equity ratio, regardless of firm’s size this
decision does create a lot of stress and pressure. Mostly small sized firms are financed by
equity and their liabilities are towards their suppliers or borrowings from banks, but when
it comes to large sized firms like Multinational Corporations (MNC’s), then they need to
look upon short and long term borrowings or bonds and stock market (A, 2014).

2.1 Thematic Literature Review

2.1.1 Financial Structure

Is the mixture of long and short term financing through debt and equity. It
represents the entire right side of balance sheet (S & Majluf N, 2000). Financial structure
includes capital structure, cost of capital and financial leverage (PS & Rao C, 2014).
Financial structure is measured by using ratio and trend analysis. Financial structure most
of the time is different from one country to another country according to their economic
conditions and business operations (SK, 2013).

2.1.2 Theories

According to Modigliani F and Miller MH, financial structure is an irrelevant

source to evaluate how well firms will perform, the earning power and the uncertainty of
risks in assets determine the value and performance of firms and it depends how to
finance future or current investments or disturbing dividends. The proposal of financial
structure stimulates financial and economic activities and operations, it also increases the
level of complexity which results higher risk and uncertainty of activities and operations
(F & Miller MH, 1958). In simple words this theory suggests that value of a firm doesn’t
depend upon its financial decisions, how to structure its finances however this was the
first theory which was proposed by Modigliani and Miller, before this theory was no
theory for financial and capital structure (Luigi & Sorin, V., 2009). This theory was
proposed under certain set of assumptions (No Taxes, No Asymmetric Information and
No Transaction Cost) which leads towards a perfect capital market condition and
proposes that there is no relationship or impact of financial decision on the performance
of firms (F & Miller MH, 1958). Although this theory is not applicable on the real world
and that’s the reason because of which this theory was criticized a lot for being just
theoretical (Danso & Adomako, S., 2014).

Pecking Order Theory of financial structure states that firm’s decisions are
based upon their preferred pecking order. When a firm will not have sufficient cash flow
available internally then they will switch towards borrowing instead of issuing equity. As
internal funds do not require any additional exposure of financial information and
flotation cost that’s why internal financing is preferred upon external sources of funds.
Exposure of financial information may lead towards a possibly less favorable or superior
business position (S & Majluf N, 1984). Decisions pertaining to finance depends upon
the cheapest sources which are available, financing can be through equity or debt, the
only thing which is considered is to maximize the value of firm, if a firm doesn’t have
funds to finance themselves through equity then the next option is to finance through debt
and if the firm chooses to finance through debt then the firm will consider different
sources of debt financing. Financing would be based upon the minimum additional cost
of asymmetric information (Luigi & Sorin, V., 2009). According to this theory financial
structure decisions are completely based upon the financing cost whether its equity or
debt, but pecking order theory more prefer equity financing more than the debt. Debt is
considered as the last option to go with and if they would be needing to issue new shares
for internal (equity) financing they would prefer debt over equity (Sheikh & Wang, Z. ,
2010).

Trade off Theory is the most well-known theory among the theories of financial
structure. This theory is a modified version of MM-Theory. This theory proposes that
financial structure does impact on firm’s performance but with some costs and benefits
pertaining to both the sources of financing equity (internally) or debt (externally).
Therefore, firms need to create a balance between cost and benefits. This theory further
elaborates that to overcome upon the market imperfections firms need to choose a
financial structure that will create a balance between the benefits and cost or which will
minimize the cost and in return it will lead to maximize the value of a firm. It accepts the
fact that both the sources of financing have their owns costs and benefits and they are
linked with the earning capacity of firms, nature of the business and risk insolvency
involved according to nature of different business. Those firms which focus on debt
financing will reap the benefits of tax advantages & those who are financing through
equity will reap the advantages by protecting themselves from the cost of financial
distress and bankruptcy (Awan & Amin, M. S., 2014). Mainly this theory focuses on the
debt financing and holds an assumption of tax shield which means that through debt
financing firms gets an advantage over tax.

Agency Theory states that both equity and debt financing hold their own costs
and firms financial structure should be determined by the agency cost of both equity and
debt. It creates a bond between finance personnel and the owners of firms. This bond is
created whenever an owner hire some finance personnel and distribute responsibilities
among them and give them an authority to take financial decisions related to firms.
Problem arises when these personnel’s start considering about their benefits rather about
holistic benefit of firm. In the context of this, the optimal financial structure of firm is
determined through understanding the financing choices and understanding between the
owner and personnel’s hired for financial decisions. It has foreseen that advantage of tax
trough debt financing greater than the cost benefit of shareholders, consequently debt
financing reduces the conflicts between owners and personnel’s which reduces the
agency cost (Parrino & Weisbach, M., 1999).

2.1.3 Conceptual Framework

This model of conceptual framework illustrate the relationship between financial
structure and financial performance of Food and Personal Care sector of Pakistan.
Financial structure is measured by Debt-Equity Ratio (Total debt/Total Equity).
Financial performance is measured by Return on Equity (Net Income/Total Equity),
Return on Asset (Net Income/Total Asset), Gross Profit Margin (Gross Profit/Sales), Net
Profit Margin (Net Profit/Sales) & Earning Per Share (Net Income/No of Shares
Outstanding).
2.1.4 Relationship Of Financial Structure with Financial Performance
For the measurement of financial performance Return on Equity (ROE), Return
on Asset (ROA), Gross Profit Margin (GPM), Net Profit Margin (NPM) & Earning Per
Share (EPS) are used. For the measurement of financial structure Debt-Equity Ratio is
used.
Previous studies have explored the relationships between financial structure and
performance. A number of authors have observed that D-E ratio is negatively correlated
with ROE, ROA, EPS, NPM and GPM (K & Ajanthan, 2013; Raheel, A. Rauf, Bashir
Ahmed, & Umara Nore, 2013; Hussain, Bahadar , & Zia , 2014; Memon, Niaz Ahmed ,
& Abbas, 2015; Nwaolisa & Ananwude Amalachukwu Chijind, 2016; Ashraf, Ahsan
Ameen , & Kiran Shahzadi, 2017).
Various studies have assessed in Pakistan, most of them are done on the industrial
sector of Pakistan which includes Cement, Pharmaceutical, Auto Assembler, Chemical,
Textile and Food sector. They have observed that D-E ratio is significantly correlated
with ROE only and non-significantly correlated with ROA, EPS, NPM and GPM (Basit
& Zubair Hassan, 2017; Amara & Dr. Bilal , 2014; Mujahid & Akhtar, 2014).
While in Sugar Sector of Pakistan its observed that D-E Ratio have a weak
positive correlation with ROA, ROE, GPM and NPM, along with that all performance
variables were non-significant to D-E Ratio (Sohail, Khurram, Usman , & Azeem, 2014).
2.3 Summary of Important Literature

Amara & D-E Ratio Data of 10 food D-E Ratio has Data of just
Dr. Bilal (Independent companies was significant effect on six years
Aziz, (2014) Variable). obtained through ROE and EPS, and was
ROE & annual financial concludes that food analyzed.
EPS reports from 2006- sector of Pakistan is Random
(Dependent 2012. not utilizing its sampling
Variables). Prais-Winsten potential mix of was
Regression and equity and debt applied on
descriptive statistics funding’s and this study.
techniques were because of
applied (E-views 9). improper allocation
of funds profits are
decreasing.
Hussain ROE, ROA, Data of 25 cement Result was showing Data of just
Muhammad, NPM & companies was a negative five years
Bahadar GPM obtained through relationship was
Shah & Zia (Independent annual financial between D-E Ratio analyzed.
ul Islam, Variables). reports from 2009- and Performance. Random
(2014) D-E Ratio 2013. Researcher sampling
(Dependent Pearson correlation concludes that was
Variable). and multiple cement firms in applied on
regression techniques Pakistan are not this study
were applied (SPSS). utilizing and and was
allocating there not
potential mix of capturing
equity and debt. the whole
cement
 sector of
Pakistan.
Sohail, D-E Ratio 33 sugar companies’ Results were Data of just
Khurram, (Independent data was collected showing weak six years
Usman & Variable). from the year of positive correlation was
Azeem, ROE, ROA, 2006-2011. between debt to analyzed.
(2014) NPM & Regression analysis, equity ratio and Random
GPM correlation analysis financial sampling
(Dependent and descriptive performance. was
Variables). statistics techniques This research applied on
were applied (SPSS). revealed this study
insignificancy in and was
sugar companies of not
Pakistan. capturing
the whole
sugar
industry of
Pakistan.
Fozia D-E Ratio Data of 141 Regression result Data of just
Memon, (Independent companies of textile was showing a six years
Niaz Ahmed Variable). industries was negative relation of was
Bhutto & ROA collected from annual debt-equity ratio analyzed.
Ghulam (Dependent financial reports from towards return on Random
Abbas, Variable). 2004-2009. asset and concludes sampling
(2015) Log linear regression that high level of was
technique was debt leads towards applied on
applied (E-views 9). lower return on this study.
asset.
Felix & D-E Ratio 10 out of 14 Oil and Results were This study
Amalachuk (Independent Gas Companies of showing a negative was based
wu, (2016 Variable). Nigeria were selected relationship of upon
ROE, ROA (1993-2013). financial structure developed
& EPS Pooled ordinary least on profitability. companies
(Dependent square, fixed effects And Concludes that of
Variables). and random model Nigerian firms Nigeria’s
techniques were should follow Oil and
applied (E-views 9). pecking order Gas
theory and should Market.
finance through
equity.
Abdul Basit D-E Ratio 50 companies were Results of this Random
& Zubair (Independent randomly selected research concludes sampling
Hassan, Variable). from Food & Care that D-E Ratio is was
(2017) ROE, ROA Products, Chemical, significantly applied on
& EPS Cement, correlated to EPS, this study.
(Dependent Pharmaceutical, Auto ROE and ROA.
Variables). Assembler and This study reveals
Textile Sector Of that equity
Pakistan (2010- financing generates
2014). more equity returns
Pearson correlation than debt financing
coefficient, multiple and opposes the
linear regression and pecking order
descriptive statistics theory.
techniques were
applied (E-views 9).
2.4 Research Gap

This research is a quantitative study as it’s based on stats obtained from annual
financial reports of the 15 out of 20 companies of food & personal care sector in Pakistan
registered in Karachi Stock Exchange, for the period of 2012-2016. These 5 companies
(Rafhan Maize Products Limited, Al Shaheer Corporation Limited, Matco Foods Limited,
Nirala MSR Foods Limited and Murree Brewery Company Limited) are excluded due to
unavailability of data, therefore this study is targeting the entire Food & Personal Care
Sector of Pakistan.

Although a lot of work was done in different industrial sector of Pakistan such as
cement, sugar, and textile etc. but these researches were not capturing the financial
structure’s impact on firm’s financial performance. In Food & Personal Care Sector of
Pakistan this might be the first research which will capture the financial structure impact
on firm’s financial performance.

This study is analyzing the validity of all the dependent variables (ROE, ROA, EPS,
GPM, NPM and T.Ass-T) & independent variable (D-E Ratio) through unit root by
applying 5 tests (Levin, Lin & Chu Test, LM, Pearson & Shin W-Stat, ADF - Fisher Chi-
Square, PP - Fisher Chi-Square and Hadri Z-Stat) on each dependent and independent
variable. Previous researches did not worked on the validity of their dependent and
independent variables.
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