Final Reasearch

THE IMPACT OF CAPITAL STRUCTURE ON
FINANCIAL PERFORMANCE
(With Special Reference to the Beverage Food and
Tobacco Industry)
WHMWD HERATH
144114
Department of Accountancy Faculty of
Business Studies and Finance Wayamba
University of Srilanka
17 th July 2019
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Declaration
I declaration that is my own work and this dissertation does not incorporate without
acknowledgement material previously submitted for a Degree or Diploma in any other
University or institute of higher learning and to the best of my knowledge and belief it does
nit contain any material previously published or written by another person except where the
acknowledgement is made in the text.
Also, hereby grant to Wayaba University of sir lanka the non-exclusive right to
reproduce and distribute my thesis, in whole or in part in print ,electronic or other medium. I
retain the right to use this content in whole or part in future work
Signature : Date :
The above candidate has carried out research for the thesis under my supervision.
Signature of the supervisor: Date:
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Acknowledgement
First I would like to express my gratitude to my supervisor, Miss. D.H.S.W.Dissanayake

Head Department of Accountancy, Faculty of Business Studies & Finance. She giving for
me guidance, assistance and courage to complete my dissertation. I also make a grateful
acknowledge for my family members for their assistant to make this research a reality.
Further I would like thankful my university friends for their moral support and help.
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Abstract
Capital structure decisions are very important for all the business companies as it directly
affected to companies’ financial performance. Capital structure is the mix of the debt and the
equity capital that can be used to finance firms’ assets. Therefore an optimal capital structure
level should be selected to achieve the companies’ financial strategy. The focus of this study
to examine significant impact of capital structure on financial performance for the beverage
food and tobacco industry listed in Colombo stock exchange. Further it examined the
relationship between capital structure and profitability and liquidity. This research used firm
size as a control variable to identify the relationship between firm size and capital structure in
the beverage food and tobacco industry. This study has selected a 20 listed companies from
the beverage food and tobacco industry as the sample for the period of 2013-2017.
Descriptive statistics, correlation analysis and regression analysis is used to analyze the data.
Descriptive results revealed that the majority of the industry firms’ capital structure consists
with high percentage of equity and low percentage of debt. Both the correlation and
regression analysis results revealed that the capital structure have a significant impact on the
financial performance in the beverage food and tobacco industry. Further regression analysis
concluded that there is a positive relationship between capital structure and profitability
(ROA =0.108, ROE=0.324). Similarly, Regression analysis conclude that there is a negative
association between capital structure and liquidity (CR=-0.011, QR=-0.009). As a control
variable, firm size illustrates varied associations with the financial performance. Based on the
regression analysis, researcher can concludes that there is significant positive relationship
between firm size and profitability and there is no any significant relationship between firm
size and Liquidity in the beverage food and tobacco industry. Therefore the researcher
suggests that companies in the beverage food and tobacco industry should maintain an
optimum mix of capital structure level in order to increase the financial performance
(Profitability and Liquidity).
Keywords: Capital Structure, Financial Performance, Liquidity, Profitability
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Dedication
I would like to dedicate this research to my parents for their persistence encouragement
Financial support. Without them , this dream never comes true.
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Table of Contents
Title page .............................................................................................................................. i

Declaration ..........................................................................................................................ii
Abstract ..............................................................................................................................iii
Dedication ..........................................................................................................................iv
Acknowledgement ............................................................................................................v
Table of Content.....................................................................................................................vi
List of Tables ..................................................................................................................vii
CHAPTER 01 ................................................................................................................11
INTRODUCTION ........................................................................................................11
1.1 Background of the Study .....................................................................................11
1.2 Problem Statement ..............................................................................................13
1.3 Research Question ...............................................................................................14
1.4 Objectives ............................................................................................................14
1.5 Significance of the Study .....................................................................................14
1.6 Limitations of the study........................................................................................14
1.7 Chapter Organization ...........................................................................................15
CHAPTER 02 ................................................................................................................16
LITERATURE REVIEW ..............................................................................................16
2.1 Introduction ..........................................................................................................16
2.2 Capital Structure ..................................................................................................16
2.3 Components of Capital Structure .........................................................................18
2.3.1 Equity Financing ...........................................................................................18
2.3.2 Debt Financing .............................................................................................18
2.4 Determinants of Capital Structure ......................................................................18
2.4.1 Asset structure ...............................................................................................18
2.4.2 Firm Size .......................................................................................................19
2.4.3 Firm Age .......................................................................................................19
2.4.4 Firm Growth .................................................................................................20
2.4.5 Firm Risk .....................................................................................................20
2.5 Capital Structure Theories ................................................................................20
2.5.1 Irrelevant Theory ........................................................................................20
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2.5.2 The trade-off theory ....................................................................................21
2.5.3 Pecking order theory ..................................................................................21
2.5.4 Market timing theory ..................................................................................22
2.5.5 Free cash flow theory .................................................................................22
2.6 Financial Performance........................................................................................22
2.6.1 Profitability .................................................................................................22
2.6.2 Liquidity ......................................................................................................23
2.7 Relationship between Capital Structure and Financial Performance ................24
2.8 Chapter Summary ..............................................................................................27
CHAPTER 03 .............................................................................................................28
METHODOLOGY ......................................................................................................28
3.1 Introduction ........................................................................................................28
3.2 Research Design ................................................................................................28
3.2.1 Conceptual Framework ...............................................................................29
3.2.2 Hypotheses Development ............................................................................ 29
3.3 Variables............................................................................................................. 29
3.3.1 Dependent Variable ....................................................................................29
3.3.2 Independent Variable .................................................................................. 31
3.3.3 Control variable ..........................................................................................31
3.4 Population and Sample ......................................................................................31
3.5 Data Collection ..................................................................................................32
3.6 Data Analysis .....................................................................................................33
3.7 Operationalization ..............................................................................................35
3.8 Chapter Summary ..............................................................................................36
CHAPTER 04 ..............................................................................................................37
DATA ANALYSIS AND DISCUSSION ................................................................... 37
4.1 Introduction ........................................................................................................37
4.2 Data Analysis .....................................................................................................37
4.2.1 Descriptive Statics .......................................................................................39
4.2.2 Correlation Coefficient ...............................................................................39
4.2.3 Regression Analysis ....................................................................................42
4.3 Testing of Hypothesis.........................................................................................45
4.4 Results and Discussion ......................................................................................45
4.5 Chapter Summery ..............................................................................................46
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CHAPTER 05 .............................................................................................................47
CONCLUSION ........................................................................................................................47
5.1 Introduction ....................................................................................................................46
5.2 Conclusion ..................................................................................................................... 47
5.3 Recommendations .......................................................................................................... 48
5.4 Limitations and Further Implications ............................................................................. 48
References .................................................................................................................................49
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List of Table
Table 3.1Variables and how to measure them……………………………….25
Table 4.1: Descriptive Statistics………………………………………………28
Table 4.2: Correlation Coefficient – Return on Assets……………….…........28
Table 4.3: Correlation Coefficient – Return on Equity…………………….…29
Table 4.4: Correlation Coefficient – Current Ratio…………………………....30
Table 4.5: Correlation Coefficient – Quick Ratio……………………………..30
Table 4.6: MODEL 01 (Regression Analysis of ROA)……………………….31
Table 4.7: MODEL 02 (Regression Analysis of ROE)…………………….....32
Table 4.8: MODEL 03 (Regression Analysis of CR)………………………...32
Table 4.9: MODEL 04 (Regression Analysis of QR)……………………….33

List of Figures
Figure 3.1: Conceptual Framework……………………………………………..18

List of Acronyms
CR -Current Ratio
CSE-Colombo Stock Exchange
QR-Quick Ratio
ROA - Return on Assets
ROE - Return on Equity
SD - Standard Deviation
CHAPTER 01
INTRODUCTION
1.1 Background of the Study

The topic of optimal capital structure has been the subject of many studies. It has been
argued that profitable firms were less likely to depend on debt in their capital structure
than less profitable ones. It has also been argued that firms with a high growth rate
have a high debt to equity ratio. Bankruptcy costs (proxies by firm size) were also
found to be an important effect on capital structure (Kraus and Litzenberger, 1973;
Harris and Raviv, 1991). If these three factors are considered as determinants of
capital structure, then these factors could be used to determine the firm’s
performance.
In practice, firm managers who are able to identify the optimal capital
structure are rewarded by minimizing a firm’s cost of finance thereby maximizing the
firm’s revenue. If a firm’s capital structure influences a firm’s performance, then it is
reasonable to expect that the firm’s capital structure would affect the firm’s health and
its likelihood of default. From a creditor’s point view, it is possible that the debt to
equity ratio aids in understanding banks’ risk management strategies and how banks
determine the likelihood of default associated with financially distressed firms. In
short, the issue regarding the capital structure and firm performance are important for
both academics and practitioners. There are many financial organizations are highly
concern about the capital structure of the organization and they make decision how
the capital utilize with maximally and effectively to earn enough return.
Capital structure plays a role in determining the risk level of the company, and
fixed cost is the key factor whether it is involved in production process or fixed
financial charges. It should be kept low if the management is likely to confront an
uncertain environment but how low or how high is the basic question. The assets of
the company can be financed by owner or the loaner. The owner claims increase when
the firm raises funds by issuing ordinary shares or by retaining the earnings which
belong to the shareholders, the loaners claim increase when the company borrows
money from the market using some instrument other than shares. The various means
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of financing represent the financial structure of the enterprises. The term capital
structure is used to represent the proportionate between debt and equity, where equity
includes paid-up capital, share premium, and all reserves & surplus.
There are many theories related to the capital structure. According to Myers,
(2001) there was no universal theory on the debt to equity choice but noted that there
were some theories that attempted to explain the capital structure mix. Myers, (2001)
cited the trade-off theory which states that firms seek debt levels that balance the tax
advantages of additional debt against the costs of possible financial distress. The
pecking order theory states that firms will borrow rather than issue equity when
internal cash flow is not sufficient to fund capital expenditure (Myers, 2001). The
theory concluded that the amount of debt will reflect the firms’ cumulative need for
external funds. The free cash flow theory on the other hand stated that dangerously
high debt levels would increase firm value despite the threat of finance distress when
a firms’ operating cash flow significantly exceed its profitable investment
opportunities.
There are two main benefits of debt for a company. The first one is the tax
shield: interest payments usually are not taxable; hence the debt can increase the value
of the firm. Another benefit is that debt disciplines managers (Jensen, 1986).
Managers use free cash flows of the company to invest in projects, to pay dividends,
or to hold on cash balance. But if the firm is not committed to some fixed payments
such as interest expenses, managers could have incentives to “waste” excess free cash
flows. That is why, in order to discipline managers, shareholders attract debt. Besides,
it is a popular practice in debt agreements between banks and borrowers to introduce
some financial covenants for firms. Managers cannot break these covenants, and
hence are bound to be more effective. In addition, the law usually guarantees a right
of partial information disclosure to the company’s debt holders, which serves as
additional managers’ supervision tool. As a result, actions of managers become more
transparent, and they have more incentives to create higher value for the owners. This
is the essence of “Free
Cash Flow Theory” of capital structure (Jensen, 1986).

The importance and the effective utilization of the capital structure has been
increased when compare with the past. Most of the listed companies are highly focus
on the strategies to invest the most appropriate way of their capital funds.
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1.2 Problem Statement
Capital structure of a firm means that the mix of financial liabilities. It has an
important issue from the strategic management view point as it is linked with the
firm’s ability to meet the various stakeholder’s demands (Roy and Miffing, 2000).
Equity and debt are the major two types of liabilities. Each of these consist with
various levels of risk and benefits.
An appropriate mix of capital structure is a vital decision for every business

organization. That decision is important not only because of the need to maximize
returns to various organizational parties, but also because of the impact of such a
decision have on an organization’s ability to deal with its competitive environment.
Following the work of Modigliani and Miller (1958 and 1963), much research has
been carried out in corporate finance to determine the influence of a firm’s choice of
capital structure on performance. The difficulty facing companies when structuring
their finance is to determine its impact on performance, as the performance of the
business is crucial to the value of the firm and consequently, its survival.
To understand how companies finance their operations, it is necessary to examine the

determinants of their financing or capital structure decisions. The research will use the
data collected from listed companies in the Colombo Stock Exchange. The empirical
research found that firm capital structure has a significant impact on financial
performance. The findings enhance the knowledge of optimal capital structure and
will help companies to make efficient financial performance in growing situations.
Each individual business Firm must be considered separately and a ratio that is
meaningful for a trading company may be completely meaning for a financial
institution. Developed countries already conducted many research in this area but
there is a lack of studies in developing countries.
In addition to that the continued poor performance coupled with closure of

listed companies has raised more questions than answers to researchers and
practitioners. Arising from the findings of Berger (2006), the capital structure
employed by such listed companies could be a reason influencing their financial
performance trends an issue that has not been given serious attention. It is on this
basis that the researcher was propelled to investigate the contribution of capital
structure on firms’ financial performance.
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1.3 Research Question
• Given the facts described in previous sections, this study attempts to address
the research question, “How does Capital Structure impact on financial
performance of the beverage food and tobacco industry in Srilanka?”
1.4 Objectives
At the end of this study aimed to
• Examine the impact of capital structure on financial performance of the
beverage food and tobacco industry
• Examine the relationship between capital structure and profitability of the

beverage food and tobacco industry.
• Examine the relationship between capital structure and liquidity of the

beverage food and tobacco industry.
1.5 Significance of the Study

The researcher hopes that the findings from the study shall be useful to the business
community since it will throw more light on the role that capital structure has in
determining financial performance.
The study will also enlighten scholars on the importance of the capital structure to
any business and will highlight areas for further research. Most of the researchers
didn’t examine the financial performance that they only examine optimal capital
structure. Which is difficult to decision? Therefore this research not only for the
financial manager of an organization but also to further researcher who can get the
idea for further research.
Effective capital structure of listed trading companies lead to better performance

of the firm. The firm must have the effective capital structure to achieve their
financial performance, because the modern industrial firm must conduct its business
in a highly complex and competitive environment.
1.6 Limitations of the study

• There are currently 297 companies listed in the CSE under 20 sectors. This
study covered only the listed Srilankan beverage food and tobacco sector.
Therefore, additional investigation is required to examine firms in the different
sectors tend to follow different capital structure patterns.
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• The study reviews only data from 2013 to 2017 time period. Therefore, the
generalizability of the findings are limited.
• Secondary data source use in this study so there may be little error in the
calculations and preparations of the financial statement.
1.7 Chapter Organization
This research is consisted with five chapters. First chapter made a brief discussion
regarding the entire research. It describes the problem statement, research questions,
research objectives and significant and limitations of this research. Chapter two
describes the review of related literatures to the variables in the research. And also it
describes the various research findings drawn by previous scholars. Chapter three
provides detail description of the research design, sample and conceptual framework,
definition of variables and data collection methods.
Chapter four contains data presentation, analysis and interpretation of findings

of the research. Researcher hopes to measure the impact of capital structure on
financial performance by regression analysis. Finally, the last chapter concludes the
total outcome of the research and gives relevant recommendations based on the
findings of this research.
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CHAPTER 02
LITERATURE REVIEW
2.1 Introduction
Daily corporate officers, professional investors, and analysts are discussing about a
company’s capital structure and financial performance. Many of them doesn’t know
what the capital structure is or financial performance. The concepts of capital
structure and financial performance are extremely important. Capital structure not
only influences the return a company earns for its shareholders, but also the survival
of the firm. Therefore, capital structure is essential for a firm’s survival and growth,
as it plays a primary role in its financial performance in order to achieve its long-term
goals and objectives. This chapter reviews broadly on previous literature related to
concepts, definitions and theories relating to this research topic and it gives a great
deal of background for the current research.
2.2 Capital Structure

Capital structure decisions play a vital role in maximizing the firm’s performance and
value (Muritala, 2012). Various researchers defined capital structure in different ways.
Khan (2012) described capital structure involves the decisions regarding the
combination of various sources of funds, which a firm uses to finance its operations
and capital investment decisions. These sources include the use of the long term and
short term debts which are called debt financing and use of preferred stock and
common stock which are called equity financing. According to Myers (2001) capital
structure means that the mix of securities and financing sources used by companies to
finance investments.
Brigham (2004) referred to capital structure as the way in which a firm finances its
o\\zxcg perations, either taking debt capital or equity capital or combination of both.
Ahmadpour and Yahyazadehfar (2010) stated that capital structure of a company is a
combination of debt capital and equity capital that make up the sources of corporate
assets. When the company which has no debt, its capital structure include only equity.
Different companies have different capital structures. The financing resources of
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companies are divided in two parts called internal financial resources and external
financial resources. On internal financing, company fund from the accumulated
earnings instead of dividing profit among shareholders. In external financing, the
company fund from the debt and stock capital Titman and Grinblatt (1998).
Pandey (2009) defined the Capital structure as a way of financing companies’

resources through which equity, debt and securities. It is a mix of equity and debt that
is needed for a company to finance assets. Firm’s capital structure is very vital as it
affects the firm’s ability of meeting the needs of their stakeholders. All the companies
are willing to develop capital structures that gives higher benefits to their stakeholders
such as equity holders, creditors, employees, customers and general society.
Capital structure of a firm means the blend of the financial liabilities. This
financial capital uncertain and critical resource for all the firms (Harris and Raviv,
1991). Equity and liability are the major classes of the liabilities. Each of these
liabilities have varied level of benefits, risks and control. When the companies finance
its assets by using the mix of debt, equity or hybrid securities, then the company’s
capital structure is the composition of their liabilities. According to Siro (2011) capital
structure means the way of firm finances for its growth and overall operations by
using variety of funds. Debt can be obtained by issuing bonds or obtaining loans. The
equity can be classified as preferred stock, common stock or retained earnings.
According to Harris and Raviv (1991), the Consensus is that “leverage

increase with fixed assets, non-debt tax shields, investment Opportunities, and firm
size, and decreases with volatility, advertising expenditure, the probability Of
bankruptcy, profitability, and uniqueness of the product.” Titman and Wessel (1988)
expressed that non-debt tax shields, uniqueness, growth, Asset structure, industry
classification, earnings Volatility, profitability and size are the main factors that affect
leverage. Several other researchers provide another capital structure. This clearly
shows that even if there is a consensus among researchers what factor may constitute
a minimum set of attributes (Harris and Raviv, 1991)
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2.3 Components of Capital Structure
2.3.1 Equity Financing

According to Brigham (2004) if any firm doesn’t use debt financing, such firm is
called as an unlevered firm. This brings about what is referred to as business risk
which is defined as riskiness inherent in the firm’s operations if it doesn’t use debt.
When a firm doesn’t use debt capital, its return on invested capital can be calculated
by dividing return on equity which is denoted by net income for the common stock
holders from common equity. This is simply means that the business risk of an
unlevered firm will be measured by the standard deviation (SD) of its return on equity
(ROE) (Brigham & Houston, 2007).
2.3.2 Debt Financing

When any firm use debt financing for their operations, they have to face a financial
risk. And also such firms are referred as a levered firms. Brigham & Houston (2007)
explained financial risk as an additional risk which have to bear on common stock
holders as a result of financing by using debt capital. Financing risk is the likelihood
that the earnings of the firm will not be as projected as a result of the method of
financing. And also he stated that this financing risk arises as debt has a fixed
financing obligation (Interest) and this obligation must be met when they are fall in
due, before the retained in earnings are divided among shareholders.
2.4 Determinants of Capital Structure
2.4.1 Asset structure

Assets structure means the type of assets that a firm possesses. This may be consist
with tangible assets and intangible assets (Psillaki & Daskalakis). Titman & wessels
(2012) mentioned that the asset structure is very important in determining capital
structure.
The degree of firm’s assets are tangible would result in having a greater liquidation
value for the firm. Bradley et al (1984) indicated that a firm which is invested heavily
in tangible assets have a higher financial leverage as they borrow at lower interest
rates if their debt is secured with such assets. According to the Wedig et al., (1988)
firms use more debts when there are durable assets to use as a collateral. As a result of
that, firms which have assets with greater liquidation value can easily find finance at
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lower cost. An empirical research which is done by Esperanca et al., (2003) found
that there is a positive relationship between asset structure and both long term debt
and short term debt.
2.4.2 Firm Size

Castanias (1983) mentioned that larger firms are tend to be more diversified and
therefore they have a lower variance in earning which result in higher ability of
bearing high debt ratios. On the other hand, smaller firms may find it relatively more
costly to resolve. Hence, lenders to larger firms have higher ability to recover their
loans than smaller firms. Simply this means that larger firms have higher debt capital.
An empirical research which is done by Sakran (2001) stated that smaller firms are
likely to use the equity financing and larger firms are likely to use the debt financing.
Most of the researchers such as khan (2012), Soumadi & Hyajneth (2010),
Martis (2013) used total assets as a measurement of the firm size. Several other
researchers such as Vijayakumar and Tamizhselvan (2010), Banchuenvijit (2012)
used both total assets and total sales as measurements of the firm size while Becker et
al., (2010) used assets, total sales and number of employees of the firms. Vijayakumar
and Tamizhselvan (2010) revealed that there is a positive relationship between the
firm size and profitability. Banchuenvijit (2012) done a research regarding firm size
and profitability. His results revealed that there is a positive relationship between total
sales and profitability while having negative relationship between the total assets and
profitability. Becker et al. (2010) found that there is a negative relationship between
firm size and the profitability of the firm.
2.4.3 Firm Age

If a particular firm have going concern and it continues their business, they have
higher capacity to take more debt. It means that age positively affected to the debt
borrowing (Wakida, 2011). Hall et al., (2004) indicated that age is positively related
with long term debt and negatively related with short term debt. However Esperanca
et al., (2003) identified that firm age is negatively associated with both short term debt
and long term debt.
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2.4.4 Firm Growth
According to the Hall et al., (2004) growth firms make a higher demand on internally
generated funds and push the firm to take borrowings. Marsh (1982) described that
high growth firms have relatively higher debt ratios. Small firms highly concentrate
on ownership. Heshmati (2002) stated that high growth firms require more external
financing and should display high leverage. Aryeetey (1994) mentioned that growing
medium sized entities are more ready to use external finance although it is difficult to
determine whether finance motivate growth or the opposite or both. When enterprises
grow thorough different stages, they are also shifting among financing sources. This
shifting can move from internal sources of finance to external sources of finance.
2.4.5 Firm Risk

Firm risk is an uncertainty which was faced by the company’s investors those who
possess securities in the firm. This risk can be minimized through the diversification
and purchasing securities from various companies (Wakida, 2011).
According to the Kale et al., (1991) risk level is the one of the primary
determinant of a firm’s capital structure. If a firm’ s operating risk is more high than
it’s earning stream, likelihood of firm defaulting and existence of bankruptcy and
agency cost is high. Firms which have more risky earnings have too low cash flows
for debt service (Johnson, 1997). Esperanca et al., (2003) identified that there is a
positive relationship between firm risk and both short term debt and long term debt.
According to the Bradley et al., (1984) there is a negative relationship between firm
risk and debt ratio.
2.5 Capital Structure Theories

Capital structure theories developed by various researchers to illustrate the different
way of financing methods which gives highest benefits to the organizations. Firstly
theories are developed by Modigliani and Miller in 1958 and subsequently number of
theories developed by various researchers.
2.5.1 Irrelevant Theory

This theory was introduced by Modigliani and Miller in 1958. It was based on several
assumptions such as no taxes, no transaction cost, no bankruptcy cost, and no equity
in borrowing cost for investors and there is no effect of debt on earnings before
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interest and tax. This theory stated that in a perfect market, there is no any effect of
the capital structure mix used by the firm to the value of the firm. In other words this
means that, when the capital structure mix is changed, firm value is remain constant.
If a firm decided to use cheaper debt, then this increases firm’s risk. As a result of that
the stock holders demand higher dividends for the high risk in their investments.
Modigliani and Miller mentioned that market value of a firm is determined by
its earning ability and its underlying asset’s risk. Hence, the weighted average cost of
capital should be constant. Modigliani and Miller Stated that capital structure is not
affected to the value of the firm. The earning ability of the assets is affected to the
value of the firms Abor (2007).
2.5.2 The trade-off theory

The trade off theory of leverage assumes that there are benefits to leverage within
capital structure used until an optimal capital structure is attained. This theory
recognized that interest on debt is tax deductible (Tax Benefit). This reduces the tax
liability. Therefore it increases tax shield. But, it is very risky for investors to invest in
a company which has high proportion of debt. As a result of that, investors demand a
high premium on stock or high dividend as a return. This theory believes that every
firm has an optimum capital structure based on trade off between benefits of using
debt and costs (Popescu, 2009).
Firm’s optimal debt ratio is determined by a trade-off between the bankruptcy

cost and tax advantage of borrowing and it is achieved at the point when the marginal
present value of the tax on additional debt is equal to the increase in the present value
of financial distress costs (Owalobi and Anyang, 2013)
2.5.3 Pecking order theory

Pecking order theory describes reasons why the internal finance is more popular than
the external finance. And also it describes why the debt is believed as the best option
for the firms. Debt finance is believed as an attractive, flexible, cheap and more
profitable (Musiega et al., 2013). This theory is based on information asymmetry. If
managers possess more information with compared to other parties, it result to
increase the information cost. As a result of that firms prefer to shares when they are
overvalued or last resort. According to the pecking order theory managers first use the
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funds which is generated by internally. If they required more funds, they move to the
cheap debt finance before moving to the equity finance Popescu (2009).
2.5.4 Market timing theory

Market timing theory was introduced by Baker and Wurgler in 2002. According to
market timing theory firms prefer to equity capital when they believe that it is
relatively lower costly, otherwise they consider about debt finance. Firms time there
equity issues, they issue new stock when the stock price is perceived to be overvalued
and buy back own shares when they are undervalued.
2.5.5 Free cash flow theory

According to Free cash flow theory, managers are forced to pay extra cash to their
investors as interest to holders of the debt and dividends to holders of equity. When
there is high debt ratio, managers should not invest in projects which have negative
NPVs making the firm profitable. Jense in 1976 mentioned that increasing leverage
instills discipline in managers as they will be cautious not to make the firm insolvent
(Owadabi and Anyang, 2013).
2.6 Financial Performance

According to the shareholders view, financial performance of a firm can be measured
by considering how better the shareholders at the end of the period with compared to
beginning of the period. This is determined by using ratios which are derived from the
financial statements. Mainly use the data of the income statement, balance sheet or
stock market prices (Berger and Patti, 2002). These ratios provide an indication
whether the owners’ objectives are achieved by making them wealthier. These ratios
can be used to compare firm’s performance with other firms and identify trends
(Severin, 2002). According to Charreaux (1997) main objective of a shareholders is to
maximize on their wealth. Financial performance of the firms must be measured for
that.
2.6.1 Profitability
Profitability is a one of the main objective in any organization. It is very essential to
earn profits to provide a return to investors for their investment and to maximize the
owner’s wealth. In order to survive in this competitive market, every company must
earn profit.
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Michael (1992) mentioned profitability as a comparison of a cash outflows
which have to be incurred for a particular alternative, with cash inflows which is
generated by that alternative. If inflows are greater than the outflows, that is called a
profit. If outflows are greater than the inflows, that is called a loss. According to
Pandey (2006) profitability can be divided to two parts called profitability in relation
to investment and profitability in relation to sales. This profitability in relation to sales
can be measured by using net profit ratio. Profitability in relation to investment can be
measured by using return on investment and return on equity ratios.
2.6.1.1 Net Profit Margin
Net profit margin can be calculated by subtracting the operating expenses, interest
expenses and taxes from the gross profit margin. Net profit margin ratio can be
calculated by dividing net profit after interest and tax form the sales. This shows the
relationship between the sales and net profit. In other words this means that the
percentage of each cash sales rupee remaining after the firm has paid all expenses and
taxes. And also it shows the management’s efficiency regarding manufacturing,
administration and selling company products (Wakida, 2011).
2.6.1.2 Return on Investment and Return on Equity

Both return on equity and return on investments are measures of profitability in
relation to investment. The return on investment can be calculated by dividing the
profit after tax from the investment. And also return on equity is calculated by
dividing the profit after tax from the net worth of the business. Return on equity ratio
shows how well the management is utilizing the shareholder’s resources.
2.6.2 Liquidity
Liquidity means that availability of cash or the ability of the business to convert its
other assets quickly in to cash. Pandey (2006) mentioned that liquidity was very
important to a business to meet its obligations when they fall due. Liquidity ratios
measures the ability of a firm to meet its current obligations.
Liquidity analysis can be done by preparing funds flow statements and cash
budgets. If a business is failed to meet its obligations as a result of insufficient
liquidity, this leads to loss of creditor confidence, poor credit worthiness and finally
business have to be closed down. There are two main ratios to measure liquidity
position of a business called current ratio and quick ratio (Pandey, 2006).
23
2.6.2.1 Current Ratio
The current ratio is a broad indicator of a firm’s liquidity and short term debt paying
ability. It stated how much current assets exceed the current liabilities on a rupee-
forrupee basic. This current ratio can be computed by dividing the current assets from
current liabilities and it measures firm’s short term solvency.
The current assets consists with cash and all other assets that can be converted
to cash within a one year such as debtors, marketable securities and inventory. Current
liabilities include the payables, creditors, accrued expenses, income tax liabilities,
short term bank loans and long term debts mature within a one year. The general rule
is that current ratio should be 2:1 or more. This means that, a firm should maintain at
least two rupees of current assets for every rupee of current liabilities. When this ratio
is greater than 1, the business has more current assets than current liabilities (Pandey,
2005).
2.6.2.2 Quick Ratio

The quick ratio exhibit the relationship between quick or most liquid assets and
current liabilities. It can be calculated by subtracting the inventory and prepaid
expenses from current assets and then divide it from current liabilities. When
calculating liquid assets, inventory and prepaid expenses. The general rule is that
quick ratio should be 1:1 or more. This means that firm should have at least one rupee
of quick assets for one rupee of current liabilities (Pandey, 2005).
2.7 Relationship between Capital Structure and Financial Performance

Relationship between Capital Structure and Financial Performance is studied by so
many researchers in various developing countries including Srilanka, and the
European countries. Some of the scholars have found the negative relationship among
these variables and some others have found positive relationships.
Several scholars found that there is a positive relationship between the capital
structure and financial performance. Holz (2002) revealed that there is a positive
relationship between the capital structure (Debt ratio) and the financial performance.
This results described the willingness of the firm manager to finance their assets by
sing borrowings to maximize the performance. Dessi & Robertson (2003) revealed
24
that the financial leverage has positive impact on the firm performance. Reason for
that is low growth firms tried to borrow money for investing in the high profitable
projects. As a result of that, firm performance is increased. .Margrates and Psillaki
(2010) found that debt ratio is positively correlated with firm performance. Mesquita
and Lara (2003) revealed that the positive relationship between the rate of return and
equity.
Most of the studies proved that the capital structure is negatively correlated
with financial performance. Ghosh (2007) found that the debt level (Capital structure)
is inversely related with the firms’ performance. The result refers to the creditors who
are using loans as disciplinary tool on the firm. This tool bases on the restrictions that
impose by creditors on the firm as prevention the firm from distribute the earnings on
the shareholders or impose restrictive conditions on the loans by increasing the
interest rates or impose sufficient collaterals on loans, thus, these restrictions will lead
firm to focus on how pay the debt burden without concerning in achieving earnings
and reflect adversely on firm performance.
Rao, Hamed, Al-yahee & Syed (2007) noted the capital structure is negatively
related with Oman firms’ financial performance. Reason for that is high borrowing
cost and the weaker debt market activities in the Oman economy. Further it describes
that, tax savings which occurred due to debt using is not adequate to meet the cost of
the debt. Abor (2007) revealed that there is a significant negative relationship between
the short term debt and the gross profit margin. For that he has used the medium sized
enterprises from Ghana and South Africa.
According to Aziz & Amara (2014) there is a negative relation of debt with
the performance in the food sector in Pakistan. For this research, they have selected 33
listed food companies in Pakistan and covered 6 financial years which is started form
2006-2012. Siro (2013) tried to identify the impact of capital structure on the
performance of listed firms in Nairobi securities Exchange. 61 companies which are
registered in security exchange were selected as sample. Research results indicates
that there was a weak positive relationship between debt ratio and performance.
Nimalanathan & Brabete (2010) were conducted a research to identify impact

of capital structure on profitability in listed manufacturing companies in srilanka.
25
Thirteen companies which are listed under manufacturing companies on Colombo
Stock Exchange were selected as a sample and research results revealed that debt to
equity ratio is positively associated with all profitability ratios. A survey done by
Khan (2012) revealed that there is a negative relationship between the debt and the
return on assets. There is a negative insignificant relationship between the debt and
return on equity ratio. For that, they have used 36 engineering sector firms listed in
karachchi stock exchange. It covers the period of 2003-2009 and used the Ordinary
Least Square regression method for that.
Velnampy & Anojan (2014) done a research to identify the impact of capital
structure and liquidity position on profitability of listed telecommunication firms in
Colombo stock exchange. For that they have used 02 telecommunication firms. This
study covered five financial years which are started from 2008-2012. Their regression
results discovered that there is no significant impact of capital structure and liquidity
position on profitability. And also correlation results revealed that there is no
significant relationship between the telecommunication firms (Listed firms) capital
structure, liquidity position and profitability.
A study done by Berzkalne (2013) to examine the impact of capital structure

on profitability. For that, he has selected 75 companies, which are listed in the Baltic
Stock Exchange for the period of 2004-2011. The results of the research revealed that
there is a significant negative relationship between the profitability and capital
structure.
A survey done by Velnampy & Niresh (2012) identified that there is a negative
relationship between the capital structure and profitability other than the association
between return on equity and debt to equity. Ten listed srilankan banks over 8 years
(2002-2009) were selected for this research. Wakida (2011) conducted a research to
identify the relationship between capital structure and financial performance of
medium sized enterprises in Uganda. 375 medium sized enterprises were selected as
sample. The research results stated that there is a significant negative relationship
between capital structure and financial performance.
26
Pratheepkanth (2011) studied impact of capital structure on business industry
performance in srilankan listed companies. Research results indicated that there is a
negative association between capital structure and financial performance. Salehi &
Biglar (2009) done a research to identify whether the capital structure decisions affect
on firms performance. 117 firms which are registered in Tehran Stock exchange were
selected as sample. This research results revealed that capital structure decisions
influence on financial performance.
Mohammadzadeh (2011) examined the firms which are listed in Tehran Stock
Exchange and revealed that firm’s performance which is measured by earning per
share
(EPS) and return on assets (ROA) are negatively related with firm’s capital structure.
Vedran (2012) done a research for the capital structure and firm performance in the
financial sector in Australia. The result of this research were revealed that there is a
significant and quadratic relationship between and firm performance. At the low
levels of leverage, capital structure is positively correlated with finance. And also at
the high levels of leverage, capital structure is negatively related with finance.
Several researchers such as Sibilkov (2007), Uremadu (2012), Kajananthan &

Achchuthan (2013), revealed that here is positive relationship between capital
structure and Liquidity. Khalaj, Farsian and Karbalaee (2013) stated that there is a
significant relationship between liquidity ratios and capital structure.
2.8 Chapter Summary

This chapter describes the review of related literatures for the research. And also it
describes the various research findings drawn by previous scholars. Majority of the
research findings revealed that there is a negative relationship between the capital
structure and financial performance. Mainly debt capital was negatively correlated
with financial performance. Some of the other results showed that there is positive
relationship between the capital structure and financial performance.
27
CHAPTER 03
METHODOLOGY
3.1 Introduction
This chapter used for explaining the data collection and analysis methods which are
used by the researcher to achieve above mentioned research objectives. Therefore this
section describes research design, sample of the study, data collection method, study
period, conceptual framework, variables and research model.
3.2 Research Design

The research design is cross sectional in nature with the aim of capturing the views of
firm owners and or managers. Cross sectional research design is selected because it
give a snap shot of the population thereby enabling the researcher draw conclusions
across a wide population about capital structure and financial performance within the
given point in time. In addition, this research is quantitative nature. Empirical studies
identified capital structure as independent variable while financial performance
becomes dependent variable.
3.2.1 Conceptual Framework

After studying of literature review, the following conceptual framework is developed
Capital structure
Financial Performance
Equity financing
Profitability
Debt financing Liquidity
to exhibit the relationship between capital structure and financial performance.
Figure 3.1: Conceptual Framework
28
3.2.2 Hypotheses Development
In order to identify the impact of capital structure on financial performance, following
hypothesis were developed.
H1:- The capital structure has significant impact on financial performance.
H2:-There is significant negative relationship between capital structure and

Profitability.
H3:- There is significant positive relationship between capital structure and liquidity.
3.3 Variables
3.3.1 Dependent Variable

Financial performance is the dependent variable in this study. It is measured by using
profitability and liquidity ratios. Therefore profitability and liquidity can be
considered as dimensions of financial performance.
Many of the researchers use profitability ratios and liquidity ratios to measure
financial performance. Wakida (2011) used both profitability ratios and liquidity
ratios to measure financial performance. Khan (2012), Pratheepkanth (2011), Siro
(2013) have used profitability ratios to measure financial performance. In this
research following ratios are used to measure the financial performance.
3.3.1.1 Profitability Ratios Return

on Assets (ROA)
This ratio measures the operating efficiency of a company based on the firm’s
generated profits from its own assets, rather than by using shareholders equity or other
liabilities. In other words this means that the rate of return earned by the firm
thorough its operating activities. This is calculated by,
ROA = Net Profit (Before Tax)
Average Total Assets
29
Return on Equity (ROE)
Return on equity ratio shows the ability of a firm to generate profits from its
shareholders investments in the company. This is calculated by,
ROE = Net Profit (After Tax) – Preference Dividend
Average Ordinary Shareholder’s Equity
3.3.1.2 Liquidity Ratios

Current Ratio
This ratio measures the company’s ability to pay short term obligations form its short
term assets. This calculated as follows.
Current ratio = Current assets
Current liabilities
Quick ratio
This ratio shows firms ability to pay their short term obligations by using their highest
liquid assets. This calculated as follows.
Quick Ratio = Current assets – (Inventory + Prepaid expenses)
Current liabilities
30
3.3.2 Independent Variable
Capital structure is the Independent Variable. It consist with two dimensions called
debt capital and equity capital. Many of the researchers’ such as Velnampy & Anojan
(2014), Siro (2013) and Velnampy & Niresh (2012) have done researches regarding
capital structure and financial performance. In this research following ratio is used to
measure the capital structure.
Debt to Equity ratio
Debt to Equity Ratio is a ratio which indicate the relative proportion of the entity’s
debt and equity used to finance the entities’ assets. This also known as the financial
leverage. This ratio is a key financial ratio which can be used to judge the company's
financial standing. If this ratio is high, company is financed by using debt capital
rather than equity capital. Optimum debt to equity is depend on the industry
(Velnampy & Anojan, 2014).
Debt to Equity Ratio = Total Liabil

Total Assets
3.3.3 Control variable
This study consider the firm size as the control variable. Large number of studies from
literature showed the effect of firm size on performance of the businesses. Normally,
larger firms have lot more resources and capabilities, achieve economies of scale and
are more diversified Frank and Goyal (2003).
Firm size can be measured by taking natural log of the totals assets and that
can be used to identify the effect of firm size on financial performance.
Firm Size = Total Assets
3.4 Population and Sample

In practically, it is difficult to make a comprehensive study to entire population.
Therefore proper sample should be selected for the analysis. According to Jankowicz
(1994) selection of sample from a population, should be based on probability.
31
Sufficient sample size should be selected to draw a reasonable conclusion.
Relatively a larger sample size will improve the validity and the quality of a research.
Hence, lager samples are better than small samples. Saunders, Lewis & Thornhill
(1996) showed that when the sample size is larger, likelihood off occurring errors in
the results are lower.
Population of this research is all the beverage food and tobacco companies
listed in CSE. The sample of this research is consisting with fifteen beverage food and
tobacco companies which are listed in Colombo stock exchange (CSE) in Srilanaka.
Colombo stock exchange has 297 companies which are representing in 20 business
sectors as at 21st April 201 (www.cse.lk).
Among all the beverage food and tobacco companies, 15 banks are selected as for this
sample. This sample is selected by using random sampling method. This study covers
five financial years which is from 2013 to 2017. Following fifteen listed beverage
food and tobacco companies were selected for this research.
Cargills (Ceylon) PLC Raigam Wayamba Salterns PLC

Ceylon Beverage Holdings PLC Ceylon Cold Stores PLC
Convenience Foods (Lanka) PLC Bairaha Farms PLC
Distilleries Company of Sri Lanka PLC Ceylon Tea Services PLC
Harischandra Mills PLC HVA Foods PLC
Keells Food Products PLC Renuka Agri Foods PLC
Lanka Milk Foods (CWE) PLC Ceylon Tobacco Company PLC
Lion Brewery (Ceylon) PLC Ceylon gold store PLC
Kotmale Holding PVT Nestle Lanka PLC
Tea small Holding Luck Lanka
Other companies which are listed under different sectors are not taken to this
analysis in order to arrive at a valid conclusion about the listed beverage food and
tobacco companies in Srilanaka.
3.5 Data Collection

All the data for this research is taken from secondary data sources. Secondary data is
the data that have been gathered from previous researches which is done by scholars.
32
Annual reports of selected companies listed in CSE in Srilanaka for the period of
2013 to 2017, are the main sources of data for this research. Among these annual
reports, mainly used statement of financial position and comprehensive income
statement for this research. And also various scholarly articles, various text books on
the subject and the internet search engines were also used.
This sample has been selected by using random sampling method and
researcher can assure that data of the analysis are true and fair as those selected
companies’ financial statements are audited by independent auditors and included the
independent audit reports for all the annual reports.
3.6 Data Analysis
In this research, quantitative approach is used to find out results. When using
numerical data, quantitative approach is very suitable. The researcher analyses the
data of the selected firms by using correlation and regression analysis. For this
purpose, Statistical Package for Social Sciences (SPSS) was used in this study.
Ultimate purpose of the making regression and correlation analysis is testing the
hypothesis.
Regression analysis is most useful measure the relationship between more than one
variables. Normally there are four assumptions in a regression analysis.
• Variables are normally distributed
According to this assumption, variables are in a normal distribution. None normally

distributed variables (Highly skewed) can distort the relationships and significant
tests.
• There is a linear relationship between the independent variables and dependent

variables.
If the relationship between the independent variables and dependent variables are in
the linear nature, regression analysis can be accurately estimate. If the relationship
between the independent variables and dependent variables are not in the linear,
regression analysis is under estimate the true relationship.
33
• Variables are measured reliably ( Without Error)
Normally some of the research variables are difficult to measure and making errors in
measurement. In a regression analysis, unreliable measurements leads to under
estimate the relationship and increase the risk occurring errors.
• Assumption of Homoscedasticity
Homoscedasticity state that the error terms along the regression are equal. When the
variance of errors differs at different values heteroscedasticity is indicated. When
heteroscedasticity is marked it can lead to serious distortion of findings and seriously
weaken the analysis.
Regression analysis can be mathematically illustrated as follows.
γ=α+βx
In here "γ" represent the dependent variable, "α"and"β"represent two constant and “x”
represent independent variable. According to this research "γ" means the financial
performance and x means the capital structure.
Correlation analysis is used to measure the relationship between each variable.

It means that correlation analysis is used to identify the relationship between
independent variables and dependent variables. Therefore, Correlation analysis can
also be carried out to find out the relationship between capital structure and financial
performance.
In here, capital structure is considered as an independent variable and

financial performance is considered as the dependent variable. By using these
independent variables and dependent variables, the following relationship can be
developed.
FP = f (CS)
34
Which shows financial performance is the function of capital structure. In here
; FP= Financial performance, CS = Capital Structure Here, financial performance is
measured by using profitability ratios ( Net profit margin, Return on assets, Return on
equity) and Capital structure is measured by using Debt and Equity ratios.
And also throughout the data analysis it is integral to maintain reliability and
validity. Since this study basically relies upon secondary data it is assume secondary
data highly reliable and validity.
3.7 Operationalization
Table 3.1: Variables and how to measure them
Variable Measures
Profitability Ratios
ROA = Net Profit (Before Tax)
Average Total Assets
ROE = Profit (After Tax) – Preference Dividend

Dependent Financial
Variable Performance
Average Ordinary Shareholder’s Equity
Liquidity Ratios
Current ratio = Current assets
Current liabilities
Quick Ratio = CA – (Inventory + Prepaid
expenses) Current liabilities
Independent Capital Debt to Equity Ratio = Total liabilities

Variable Structure
Total equity
Control
variable Total value of the assets
35
3.8 Chapter Summary
Methodology chapter include the research design, conceptual framework, variables,
research hypotheses, data collection methods, data analysis and operationalization of
the research. Specially the way of measuring variables, how to select the sample, how
to collect data and analyze them are described in detailed manner in this chapter. It
mainly describes that how the relationship between capital structure and financial
performance will be measured.
36
CHAPTER 04
DATA ANALYSIS AND DISCUSSION
4.1 Introduction
This chapter present the results of the analysis performed on the data collected to test
the research hypothesis made in the study and answer the research questions. The
main objective of this data analysis is to identify the impact of capital structure on
financial performance in the beverage food and tobacco industry. This analysis
consists with three types of analysis such as descriptive statistics, correlation analysis
and multiple regression analysis. Under the descriptive statistics, Mean, Standard
deviation, Minimum, Maximum and Skewness are calculated and correlation
coefficient is calculated in the correlation analysis. Finally, in the regression analysis,
regression coefficient is calculated. This analysis was carried out with the Statistical
Package for Social Sciences.
4.2 Data Analysis
4.2.1 Descriptive Statics

Descriptive statistics are used to summarize and describe the behaviors and main
features of the variables which are used in the study. In this research, there are several
independent, dependent and control variables. Descriptive statistics are foremost from
uncertain statistics, in that descriptive statistics aim to summarize sample, rather than
use the data to learn about the population that the sample of data is thought to
represent. Some measures that are commonly used to describe a data set are measures
of central tendency and measures of variability or diffusion. Central tendency
measures consists with the mean, medium and mode, while variability measures
consists with the standard deviation, the minimum and maximum values of the
variables.
Table 4.1: Overall Descriptive Statics of Variables
Table 4.1 consists the descriptive statistics of the variables for the research by
covering the period of 2013/2017. According to the results of the table 4.1, Mean of
the Return on Assets is 5.28%. This means the companies of the beverage food and
37
tobacco companies listed in CSE averagely earn Rs.5.28 by investing Rs.100 in their
assets. Minimum and maximum ROA in the industry is -0.15 and 153.99. This shows
that there is a high variation in the ROA among the industry firms. Further it describes
that while some firms are earning higher return for some years, several other firms are
bearing losses for some years. Standard deviation for the ROA this industry is
24.08%. This also shows that there is a higher dispersion. Skewness for the ROA is
4.88%. Mean value Return on Equity is 3.35%. This also show that the performance
of the beverage food and tobacco industry is low. Minimum and maximum ROE in
the industry is 5% and 34.2%. Standard deviation for the ROE is 5.7%. This also
shows that there is a low variance in the industry.
Further descriptive statistics reveals that the Mean value for the Current Ratio
and Quick Ratio are 3.14% and 2.37%. This shows that the average industry firm have
a good liquidity position and financial performance as these rates are exceeded the
normal industry requirements. Minimum and maximum value for the Current Ratio is
0.18 and 17.36. Minimum and maximum values for the Quick Ratio is -9.53% and
15.21%. This reveal that while some firms are having higher liquidity position for
some years, several other firms are facing liquidity deficiencies for some years.
Standard deviation for the Current Ratio and Quick Ratio are 3.61% and 3.37%.
The Mean of the Debt to Equity Ratio is the 1.22%. This reveals that the
minimum of the company assets are financed by using equity capital and remain
financed by using debt capital in the industry. This means that less of the firms in the
industry willing to use equity capital as their financial source. The Minimum and
maximum values for the Debt to Equity Ratio are 0.01% and 22.4%. This shows that
the Debt to Equity composition varies substantially among the listed beverage food
and tobacco companies. Further revealed that there is no any company which is 100%
financed by debt or equity. All the companies are financed as a mix debt and equity.
The Standard deviation for the Debt to Equity Ratio is 2.63%. It shows the diversity
of the Debt to Equity Ratio (Capital Structure) in the industry.
Average total assets is 9.52 and this is the average log value of the assets. It
reveals that majority of the industry firms are large scale firms. Standard deviation for
the total assets is the 0.60. Skewness for the total assets is 0.30.
38
Table 4.1: Descriptive Statics
Variable Mean Standard Minimum Maximum Skewness
Deviation
Return on Assets 5.28 24.81 -0.151 153.74 4.882
Return on Equity 3.35 5.783 -0.556 34.282 2.669
Current Ratio 3.14 3.61 0.18 17.369 2.261
Quick Ratio 2.371 3.37 -9.53 15.213 1.454
D/E Ratio 1.221 2.638 0.15 22.843 6.014
Total Assets 9.5 0.60 8.45 10.79 0.30
Source: Survey Results, 2015
4.2.2 Correlation Coefficient

Correlation coefficient is used to measure and interpret the relation between the
independent and dependent variables. In this study, Pearson correlation is used to
measure the relationship between independent and dependent variables. Value of the
correlation coefficient can be positive, negative or zero. The correlation coefficient
ranges from -1 to 1. Value of 1 means that there is a perfect positive relationship.
Value of -1 means that there is a perfect negative relationship.
This study consist of two independent variables (Including the control variable)
and four dependent variables. Whether there is a positive correlation or negative
correlation between the variables and the significance level of those variables are
identified in here. Correlation coefficient for four dependent variables are calculated
separately. Table 4.2 represent the correlation coefficient between independent
variables and ROA.
Table 4.2: Correlation Coefficient – Return on Assets
ROA D/E TA
ROA 1
D/E -0.061(**) 1
TA -0.126(*) 0.103 1
** Correlation is significant at the 0.01 level (2-tailed).
39
* Correlation is significant at the 0.05 level (2-tailed). Source:
Survey Results, 2015
As illustrated in the table 4.5, there are negative relationships between both
independent variables and the dependent variable. As correlation coefficient between
debt to equity and return on assets is approximately 0.5, there is a strong positive
relationship between the debt to equity and return on assets. There is weak positive
relationship between the Total assets and the Return on assets in the significant level
of -0.06. It means the firm size is negative correlated with Profitability. There is no
any significant relationship between the independent variables (Capital structure and
firm size).
Table 4.3 illustrates the correlation coefficient of independent variables with

ROE in detail.
Table 4.3: Correlation Coefficient – Return on Equity
ROE D/E TA
ROE 1
D/E 0.053(**) 1
TA 0.503(*) 0.103 1
** Correlation is significant at the 0.01 level (2-tailed).

* Correlation is significant at the 0.05 level (2-tailed).
According to the table 4.3, there are positive relationships between both independent
variables and the dependent variable same as table 4.2. There is week positive
relationship between the debt to equity and return on equity as the correlation
coefficient is above the 0.5 level. Same as the correlation between the Total assets and
the Return on assets, there is weak positive relationship between the Total assets and
the Return on Equity in the significant level of 0.05.
Table 4.4 illustrates the correlation coefficient of independent variables with

Current Ratio.
40
Table 4.4: Correlation Coefficient – Current Ratio
CR D/E TA
CR 1
D/E -0.222(**) 1
TA -0.173 0.103 1
** Correlation is significant at the 0.01 level (2-tailed). Source:

Table 4.4 revealed that there are negative relationships between both independent
variables and the dependent variable. Both Debt to Equity and Current Ratio
(Liquidity) have weak negative relationship in the significant level of 0.001. There is
no any significant relationship between the Total assets and Current ratio. It means
that there is no relationship between the firm size and Liquidity.
Table 4.5 illustrates the correlation coefficient of independent variables with Quick
Ratio.
Table 4.5: Correlation Coefficient – Quick Ratio
QR D/E TA
QR 1
D/E -0.189(**) 1
TA -0.166 0.103 1
** Correlation is significant at the 0.01 level (2-tailed). Source:

Table 4.5 illustrated that there are negative relationships between both independent
variables and the dependent variable. These relationships are similar to the results of
41
the Table 4.4. There is weak negative relationship between the Debt to Equity and
Quick Ratio (Liquidity) in the significant level of 0.001 same as Table 4.4. There is
no any significant relationship between the Total assets and Quick ratio. It means that
there is no relationship between the firm size and Liquidity.
Overall results revealed that there is positive significant relationship between
capital structure and profitability as the Debt to Equity Ratio and Both ROA and ROE
show significant negetive positive relationships. On the other hand, there is negative
weak relationship between both capital structure and Liquidity position due to weak
negative correlation coefficient. There is weak positive relationship between the firm
size and profitability and there is no significant relationship between the firm size and
liquidity.
4.2.3 Regression Analysis

Linear regression is an approach to modeling the relationship between a dependent
variable y and one or more independent variable denoted X. when there is of one
independent variable, it is called simple linier regression. When there is more than one
independent variable, it is called multiple linear regressions. This study consist with
two independent variables. Therefore this is a multiple linear regression. This study
consists of four dependent variables which contribute to measure the financial
performance. Therefore four regression models have to be developed to identify the
relationship between dependent variables and independent variables.
Table 4.6: MODEL 01 (Regression Analysis of ROA)
R2 = 1.018 F = 0.910466 Standard .Error = 2.49

B Significance
Constant 7.89 0.0142
Debt to Equity -0.459 0.6298
TA -2.34 0.2319
This table illustrate summery of regression analysis for dependent variable ROA. The
R squared indicates the explanatory power of the independent variable. When this
value is high, higher the representation of independent variables. According to the
Table 4.6, Adjusted R square for Model 1 is 0.257. This means that 10 % of the
42
variation in ROA is explained by the independent variables. The remaining
percentage (89.9%) is influenced with other factors that effect to the ROA. The
standard error of the estimate is 3.16, which explains how representative the sample is
like to be of the population. F-value indicates that at least one of the independent
variables is significantly related to the performance. Regression analysis revealed that
there is a significant positive relationship between the Debt to Equity and Return on
assets as p- value is less than
0.05. Further it describes that, if the ROA is increased by 1%, Debt to Equity give
10.8% contribution for that. There is a significant positive relationship between firm
size and ROA at 90 percent significance level as p-value is greater than 0.05 but less
than 0.1.
Table 4.7: MODEL 02 (Regression Analysis of ROE)

B Significance
Debt to Equity 0.003 0.985
TA 2.25 0.000
According to the Table 4.7, Adjusted R square for Model 2 is 0.253. This describes
that
23.3% of the variance of ROE is affected by the independent variables while
remaining 76.7% of the variance with ROE is affected by other factors. There is a
significant positive relationship between the Debt to Equity and Return on Equity as
p- value is less than 0.05. Further Regression analysis revealed that there is a
significant positive relationship between firm size and ROE at 90 percent significance
level
43
Table 4.8: MODEL 03 (Regression Analysis of CR)

B Significance
TA -4.23 0.126
Table 4.8 reveals that, Adjusted R square for Model 3 is 0.072. This means that the
7.2% of the variance of Current Ratio (Liquidity) is affected by the independent
variables. Balance of the 82.8 is affected by the several other factors to the variance of
Current Ratio (Liquidity). According to the regression analysis there is significant
negative relationship between Debt to Equity and Current Ratio (Liquidity) as the as
p- value is less than 0.05.There is no significant relationship between firm size and
Current Ratio (Liquidity). Reason for that is p- value is greater than the 0.05 and 0.1
level.
Table 4.9: MODEL 04 (Regression Analysis of QR)

B Significance
TA 3.89 0.136
According to the Table 4.9, Adjusted R square for Model 4 is 0.057. This means that
5.7 % of the variation in QR (Liquidity) is explained by the independent variables.
The remaining percentage (94.3%) is influenced with other factors that effect to the
QR (Liquidity). According to the regression analysis there is significant negative
relationship between Debt to Equity and Current Ratio (Liquidity) as the as p- value is
less than 0.05.There is no significant relationship between firm size and Current Ratio
(Liquidity) as the p- value is greater than the 0.05 and 0.1 level.
44
Overall regression results revealed that there is significant positive relationship
between capital structure and profitability as per the regression coefficients. On the
other hand, there is significant negative relationship between both capital structure
and Liquidity position. There is significant positive relationship between the firm size
and profitability and there is no significant relationship between the firm size and
liquidity.
4.3 Testing of Hypothesis

H1:- The capital structure has significant impact on financial performance.
Based on the empirical results of this study, H1 is accepted. Regression analysis

results revealed that the capital structure has significant impact on financial
performance. Because p- value is less than 0.05 or 0.1 for both profitability and
liquidity.
H2:-There is significant negative relationship between capital structure and

Profitability.
Based on the empirical results of this study, H2 is rejected. Regression analysis
revealed that there is positive significant relationship between capital structure and
profitability as the p- value is below the 0.05 for ROE and ROA.
H3:- There is significant positive relationship between capital structure and liquidity.
Based on the empirical results of this study, H3 is also rejected. Regression

analysis results revealed that there is negative significant relationship between capital
structure and liquidity as the p- value is less than the 95% significant level.
4.4 Results and Discussion

After analyzing the calculated data, regression results revealed that the capital
structure has significant impact on financial performance.
Some of the previous researchers such as Pratheepkanth (2011), Holz (2002)

and Dessi & Robertson (2003) also revealed that the capital structure has significant
impact on financial performance. Further these results revealed that there is a positive
relationship between capital structure and profitability (ROE, ROA). Reason for this
type of positive relationship in this industry is that majority of the firms are highly
45
using the equity capital with compared to debt capital. As a result of that, firms don’t
want to pay interest expenses. This leads to increase the profitability of the industry.
Several other researchers such as Mesquita and Lara (2003), Holz (2002) agreed to
these results. This recognized relationship contradicts with the findings of Velnampy
& Niresh (2012) and Abor (2007). They revealed that there is a negative relationship
between capital structure and profitability. Further regression results described that
there is negative relationship between capital structure and liquidity (CR, QR).
Reason for that is most of the companies are issuing right shares and bonus shares to
their existing shareholders. As a result of that, company’s equity capital is increased.
But the cash level is not increased due to shares are issued at freely or lower prices.
Kajananthan & Achchuthan (2013) mentioned that the capital structure impact on the
profitability.
Apart from that, relationship between control variables also studied in this
research. Regression anlysis described that firm size is impact on the financial
performance. Further it describes that there is significant positive relationship between
firm size and profitability and there is no any significant relationship between firm
size and Liquidity. Reason for positive relationship between firm size and profitability
in this industry is the larger firms are able to reduce their production cost by gaining
economies of scale in to their production process. Several researchers such as
Banchuenvijit (2012), Vijayakumar and Tamizhselvan (2010) and Velnampy and
Nimalathasan (2010) stated that there is a positive relationship between firm size and
profitability
4.5 Chapter Summery

This chapter present the results of the analysis performed on the data collected to test
the propositions made in the study and answer the research questions. Mainly research
analysis is done under three categories called Descriptive Statics, correlation analysis
and regression analysis. Based on the research findings, identified the relationship
between the independent variables and dependent variables. Finally research
hypothesis were tested and further described the research findings.
46
CHAPTER 05
CONCLUSION
5.1 Introduction
This chapter describes the research findings, recommendations, and further
implications for future researches briefly. This is a summary of the entire research. It
provides overall knowledge to the users regarding the research.
5.2 Conclusion
This study examined the capital structure and its impact on financial performance of
the beverage food and tobacco industry listed in Colombo Stock Exchange. Further it
examined the relationship between capital structure and profitability and liquidity.
This research used firm size as a control variable to identify the relationship between
firm size and capital structure in the beverage food and tobacco industry. This study
covered 15 listed companies from the beverage food and tobacco industry as the
sample by covering period of 2013-2017.
Based on the research findings, researcher can conclude that the capital
structure have a significant impact on the financial performance. Both the correlation
and regression analysis gave the above result. Regression analysis further revealed
that the positive relationship between capital structure and profitability as the p- value
is less than the 0.05. Further regression coefficient describes that if the ROA and ROE
is increased by 1%, debt to equity gives 10.8% and 32.4% contribution for this,
respectively. Not only that, Regression analysis explains that there is a negative
relationship between capital structure and liquidity ratios in this industry.
As a control variable, firm size provides varied associations with the financial
performance. Based on the regression analysis, researcher can concludes that there is
significant positive relationship between firm size and profitability and there is no any
significant relationship between firm size and Liquidity in the beverage food and
tobacco industry.
47
5.3 Recommendations
Research results (Descriptive statistics) revealed that the capital structure of beverage
food and tobacco industry consists with high percentage of equity and low percentage
of debt. This capital structure is positively affected for profitability and negatively
affected for liquidity of the companies in the industry. Therefore the companies of this
industry must maintain an optimum mix of capital structure. They shouldn’t further
increase their equity level to gain more profits as it cause to reduce their liquidity.
Although high debt level increase their liquidity, it cause to decrease their
profitability. Reason for that is, companies have to pay large amount of company
resources as an interest expenses. Therefore, companies should try to obtain loans
under lower interest rates.
Further research results revealed that firm size is positively related with
profitability. Therefore the companies in this industry should try to further increase
their firm size and capacity to gain the economies of scale for their production.
Inflation and exchange rate also affect the listed company’s performance. So,
government should consider the economic growth to control the inflation.
5.4 Limitations and Further Implications

Several limitations can be seen in this study. There are currently 297 companies listed
in the CSE under 20 sectors. This study covered only the listed Srilankan beverage
food and tobacco sector. Therefore, additional investigation is required to examine
firms in the different sectors tend to follow different capital structure patterns. The
study reviews only data from 2013 to 2017 time period. Therefore, the
generalizability of the findings are limited. Researches should be conducted for the
different periods.
Secondary data source use in this study so there may be little error in the
calculations and preparations of the financial statement. Both primary secondary and
secondary data can be used to get a better results. There are several other factors such
as ownership status, composition of assets and liabilities, regulations and restrictions
of the government, which affect the industry performance are not focused in this
study. Therefore further investigation is required to examine regarding what are the
factors other than capital structure influences on financial performance.
48
This study is conducted with the help of using SPSS-16 version. Future researches
can be done by using other different latest statistical packages.
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THE IMPACT OF CAPITAL STRUCTURE ON

Signature of the supervisor: Date:

First I would like to express my gratitude to my supervisor, Miss. D.H.S.W.Dissanayake

Keywords: Capital Structure, Financial Performance, Liquidity, Profitability

Title page .............................................................................................................................. i

Table 3.1Variables and how to measure them……………………………….25

Table 4.1: Descriptive Statistics………………………………………………28

Table 4.2: Correlation Coefficient – Return on Assets……………….…........28

Table 4.3: Correlation Coefficient – Return on Equity…………………….…29

Table 4.4: Correlation Coefficient – Current Ratio…………………………....30

Table 4.5: Correlation Coefficient – Quick Ratio……………………………..30

Table 4.6: MODEL 01 (Regression Analysis of ROA)……………………….31

Table 4.7: MODEL 02 (Regression Analysis of ROE)…………………….....32

Table 4.8: MODEL 03 (Regression Analysis of CR)………………………...32

Table 4.9: MODEL 04 (Regression Analysis of QR)……………………….33

Figure 3.1: Conceptual Framework……………………………………………..18

CSE-Colombo Stock Exchange

ROA - Return on Assets

ROE - Return on Equity

1.1 Background of the Study

Cash Flow Theory” of capital structure (Jensen, 1986).

An appropriate mix of capital structure is a vital decision for every business

To understand how companies finance their operations, it is necessary to examine the

In addition to that the continued poor performance coupled with closure of

• Examine the relationship between capital structure and profitability of the

• Examine the relationship between capital structure and liquidity of the

1.5 Significance of the Study

Effective capital structure of listed trading companies lead to better performance

1.6 Limitations of the study

Chapter four contains data presentation, analysis and interpretation of findings

2.2 Capital Structure

Pandey (2009) defined the Capital structure as a way of financing companies’

According to Harris and Raviv (1991), the Consensus is that “leverage

2.3.1 Equity Financing

2.3.2 Debt Financing

2.4 Determinants of Capital Structure

2.4.1 Asset structure

2.4.2 Firm Size

2.4.3 Firm Age

2.4.5 Firm Risk

2.5 Capital Structure Theories

2.5.1 Irrelevant Theory

2.5.2 The trade-off theory

Firm’s optimal debt ratio is determined by a trade-off between the bankruptcy

2.5.3 Pecking order theory

2.5.4 Market timing theory

2.5.5 Free cash flow theory

2.6 Financial Performance

2.6.1.2 Return on Investment and Return on Equity

2.6.2.2 Quick Ratio

2.7 Relationship between Capital Structure and Financial Performance

Nimalanathan & Brabete (2010) were conducted a research to identify impact

A study done by Berzkalne (2013) to examine the impact of capital structure

Several researchers such as Sibilkov (2007), Uremadu (2012), Kajananthan &

2.8 Chapter Summary

3.2 Research Design

3.2.1 Conceptual Framework

to exhibit the relationship between capital structure and financial performance.

Figure 3.1: Conceptual Framework

H1:- The capital structure has significant impact on financial performance.

H2:-There is significant negative relationship between capital structure and

3.3.1 Dependent Variable

3.3.1.1 Profitability Ratios Return

ROA = Net Profit (Before Tax)