www.tjprc.org editor@tjprc.

org

INTERRELATION BETWEEN CAPITAL STRUCTURE AND PROFITABILITY OF FMCG
COMPANIES OF INDIA
GURMEET SINGH H
1, 2

1
N.R. Institute of Business Management, Ellisbridge, Ahmedabad, Gujarat, India
2
Gujarat Technological University, Gandhinagar, Gujarat, India

ABSTRACT
Capital structure is the composition of debt and equity capital that comprise a firms financing its assets and can
be rewritten as the sum of net worth plus preferred stock plus long-term debts. Capital structure is one of the most complex
areas of financial decision making due to its interrelationship with other financial decisions variables. This paper focuses
on interrelation between capital structure and profitability of FMCG companies of India. To proceed with this, the capital
structure of listed firms has been analyzed by adopting an econometric framework over a period of five years. Estimating
regression analysis and checking the relationship of the estimated model through Correlation Coefficient Test, I found that
the profitability of the firm and its financial leverage have an insignificant impact on the capital structure of the studied
firms during the examined period. Hence, the study is unable to establish any significant relation between profitability and
financial leverage effect on the capital structure of a firm.
KEYWORDS: FMCG, India, Capital Structure, Profitability
INTRODUCTION
Capital structure is considered to be the different alternatives used by a firm in financing its assets. Generally, a
company can go for different mixes of debts, equity, or other financial arrangements. It can combine bonds, lease
financing, bank loans or many other options with equity in an overall attempt to boost the market value of the firm.
In order to maximize the overall value, companies differ with respect to capital structures. This has given birth to different
capital structure theories that attempt to explain the variation in capital structures of companies over time or across regions.
On the other hand, empirical evidence is also not sometime consistent in substantiating a particular capital structure theory.
This paper answers the question that how capital structure impact profitability of listed Indian firms belonging to the
FMCG industry.
In 1958, Miller and Modigliani published theoretical and empirical research on the area of capital structure.
However, most of the research work has been carried out in developed economies and very little is known about the capital
structure of firms in developing economies. With this very little research, we are not sure whether conclusions can be
drawn in developed economies are valid for developing countries too; or a different set of factors influence capital
structure decisions in developing countries? Rajan and Zingales (1995) studied the G-7 countries while Booth et al (2001)
extended this work by including some data from emerging markets. The conclusions from these studies were that there
were some common features in the capital structures of firms in different countries but that further research was necessary
to identify the determinants of capital structure in particular institutional settings or countries.
International Journal of Accounting and
Financial Management Research (IJAFMR)
ISSN(P): 2249-6882; ISSN(E): 2249-7994
Vol. 4, Issue 3, Jun 2014, 51-58
TJPRC Pvt. Ltd.

52 Gurmeet Singh H

Impact Factor (JCC): 4.4251 Index Copernicus Value (ICV): 3.0
India is a developing country with two stock exchanges, the Bombay Stock Exchange (BSE) being the largest one.
More than 4000 companies are listed on BSE. Like other developing economies, the area of capital structure is relatively
unexplored in India. In all previous researches, capital structure has never been taken as a dependent variable but would be
discussed in this new way here.
This phenomenon resulted from steep depreciation of Indias currency vis-a-vis international currencies and
increase in market interest rates / inflation. The growth in the FMCG sector had naturally also given impetus to the allied
FMCG vendor industry, which also faced problems due to the recent fall in demand. Notwithstanding a manifold increase
in car production in India during the last few years, India still stands relatively low in terms of motorization when
compared globally and even to its neighbors. It is clear that despite a tremendous increase in demand of FMCG in the
country; India still remains one of the less motorized nations of the world with 11 cars per thousand persons.
REVIEW OF LITERATURE
Modigliani and Miller (1958) attempted to look into the relationship between capital structure and
earnings/market value. Their argument was that in an economy without corporate and personal taxes, capital structure had
no effect on firm value. In other words under some given restrictive assumptions, an un-leveraged firm had the same
market value as a leveraged firm. They subsequently included corporate taxes in their model and showed that earnings and
market value of the firm will be the maximum if 100% debt is used by a firm for financing its assets. Their main
assumption was that business risk can be fairly assessed by the standard deviation of operating income (EBIT) and that all
present and future potential investors share similar expectations about corporate earnings and the chances of variation in
those earnings. Another key assumption was they assumed the companies stocks and bonds were traded in a perfect
market. Yet another important assumption was that rate of interest on debt was a risk-free rate for firms as well as
individuals. Their model with corporate taxes showed that debt brings benefits due to availability of tax shield due to
interest being treated as a tax deductible expense.
Mandelker and Rhee (1984) in their study discovered a relationship between Degree of Operating Leverage
(DOL), Degree of Financial Leverage (DFL) and beta. They were able to show empirically that DOL and DFL explained
between 38 to 48 percent changes in a cross-section of data. Profitability is a strong point of dissent between the two
theories presented by Myers (1984) i.e. Pecking Order Theory (POT) and Static Tradeoff Theory (STT). Myers divided the
contemporary thinking on capital structure into two theoretical currents. The first one is the Static Tradeoff Theory (STT),
which explains that a firm follows a target debt-equity ratio and then behaves accordingly. The benefits and costs
associated with the debt option sets this target ratio. These include taxes, cost of financial distress and agency costs.
Second, the Pecking Order Theory (POT) put forward by Myers (1984) and Myers and Majluf (1984), stated that
firms follow a hierarchy of financial decisions when establishing their capital structure. Initially, firms prefer to finance
their projects through internal financing i.e. retained earnings. In case they need external financing, they first apply for a
bank loan then for public debt. As a last resort, the firm will issue equity to finance its project. Thus according to POT the
profitable firms are less likely to incur debt for new projects because they have the available internal funds for this purpose.
For the STT, the higher the profitability of the firm, the more reasons it will have to issue debt, thereby also
reducing its tax burden. On the other hand, the POT presupposes that larger earnings lead to increase in the main source
that firms choose to cover their financial deficit: retained earnings. Therefore, the STT expects a positive relationship
Interrelation Between Capital Structure and Profitability of FMCG Companies of India 53

www.tjprc.org editor@tjprc.org
between profitability and leverage, whereas the POT expects exactly the opposite. Also for the Static Tradeoff approach,
the larger the firm, the greater the possibility it has of issuing debt, resulting in a positive relationship between debt and
size. One of the reasons for this is that the larger the firm, the lower is the risk of bankruptcy. Large firms do not consider
the direct bankruptcy costs as an active variable in deciding the level of leverage because larger firms, being more
diversified, have less chances of bankruptcy (see, for details Titman and Wessels (1988)).
Signaling Theory originally developed by Ross (1977), explains that debt is considered as a way to highlight
investors trust in the company, that is, if a company issues debt it provides a signal to the markets that the firm is
expecting positive cash flows in the future, as the principal and interest payments on debt are a fixed contractual obligation
which the firm has to pay out of its cash flows. Thus, higher level of debt shows the managers confidence in future cash
flows. Another impact of the signaling factor in the Pecking Order Theory is the problem of the under-pricing of equity.
If a firm issues equity instead of debt for financing its new projects, investors will interpret the signal negatively.
Since managers have superior information about the firm than investors, they might issue equity when it is overpriced.
Larry et al. (1995) reported that there exists a negative relation between leverage and future growth. This relation
is negative for firms whose growth opportunities are either not recognized by the capital markets or are not sufficiently
valuable to overcome the effects of their debt overhang. They also confirmed that leverage does not reduce growth for
firms known to have good profit opportunities. To examine the relation between leverage and growth they used data set
over a period of 20 years and they found a strong negative relation between them.
In India, Limited research work exists on the area of capital structure, like Booth et al (2001) studied 10
developing countries including India. However, this study was confined only to top 100 index companies. Second study by
Shah and Hijazi (2004) was an improvement on the first one as it included all non-financial firms listed on KSE for the
period 1997-2001. However, the second study too was basic in nature in terms of its use of pooled regression model
avoiding the fixed effects and random effects models. Attaullah Shah and Safiullah Khan (2007) have extended the work of
Shah and Hijazi (2004) by including more years, using relevant models of panel data and including more explanatory
variables.
Particularly in FMCG Industry of India, the only work found in this regard is by Zubairi and Zubairi and Rashid.
In both these papers, once again Profitability of this sector has been checked through different variables. Thus this paper
aims at targeting this knowledge gap by checking how profitability in turns impacts capital structure along with financial
leverage.
DATA AND VARIABLES
Source of Data
The study is based on the data taken from the State Bank of India publication Balance Sheet Analysis of Joint
Stock Companies Listed on The Bombay Stock Exchange 2008-2013. This publication provides useful information on
key accounts of the financial statements of all listed firms of BSE for six year period.
The Sample
The study has focused on the FMCG sector of India. Initially all the 20 firms listed on the Bombay Stock
Exchange were selected. However, after screening out the firms with incomplete data we were left with 11 firms.
54 Gurmeet Singh H

Impact Factor (JCC): 4.4251 Index Copernicus Value (ICV): 3.0
The study used the financial data of these firms over years 2008 to 2013 (the computation of the variables are given in
Annexure A). Hence, we have 55 firm-year observations.
VARIABLE DESCRIPTION
Dependent and Independent Variables
After discussing the various theories of capital structure, now we discuss the potential dependent and independent
variables for our study. We take the debt to equity ratio as a proxy for capital structure (dependent variable).
For independent variables there can be many. However, we take only two main independent variables namely, profitability
(EBT/TA) and financial leverage (EBT/EBIT) of the firm.
Capital Structure
Capital Structure has been uniquely taken as the dependent variable here. It indicates the mix of equity financing
and debt financing supporting the assets side of the companys balance sheet. In previous studies, it has never been taken
as a dependent variable. The typical debt to equity ratio has been used here as proxy for capital structure measurement.
The aim is to check if either profitability or degree of financial leverage or both have any effect in bringing about capital
structure change.
Profitability
We measure profitability as the ratio of net income before taxes divided by total assets. Previous studies have used
earnings before interest and taxes (EBIT) divided by total assets, as a measure of profitability as it is independent of
leverage effects. However we use the said measure as the data taken from the State Bank of India publication does not
permit us to calculate (EBIT).
Degree of Financial Leverage
Financial leverage results from the presence of fixed financial costs in a firm's income stream. The extent of the
presence of fixed financial costs in a firm's income stream is measured by the degree of financial leverage (DFL).
Financial leverage increases expected return on equity, but it also increases the risk faced by the shareholders. The business
risk part of total risk is affected by operating leverage, whereas financial leverage affects financial risk thus affecting the
total risk of the firm. Though capital structure theories consider long term debt as a proxy for financial leverage but we
measure degree of financial leverage (DFL) as the ratio of earnings before taxes (EBT) to earnings before interest and
taxes (EBIT).
Thus the hypotheses to be tested are as follows:
Hypothesis 1:
HO1: Profitability does not significantly affect Capital Structure
HA1: Profitability does significantly affect Capital Structure
Hypothesis 2:
HO2: Financial Leverage does not significantly affect Capital Structure
HA2: Financial Leverage does significantly affect Capital Structure
Interrelation Between Capital Structure and Profitability of FMCG Companies of India 55

www.tjprc.org editor@tjprc.org
METHODOLOGY
The Regression Model
Regression models are used to predict one variable from one or more other variables. This study uses panel
regression analysis. Panel data analysis facilitates analysis of cross-sectional and time series data. We use the pooled
regression type of panel data analysis. The pooled regression, also called the Constant Coefficients model, is one where
both intercepts and slopes are assumed constant. The cross section company data and time series data are pooled together
in a single column assuming that there is no significant cross section or inter temporal effects.
Panel data follows a given sample of individuals over time, and thus provides multiple observations on each
individual in the sample. Panel data combines the features of time series and cross-section. It provides information on a
number of statistical units for a number of years. Panel data for economic research has several advantages over
cross-sectional or time- series sets. Panel data usually provides the researcher a large number of data points, increasing the
degrees of freedom and reducing the co-linearity among explanatory variables; hence improving the efficiency of
econometric estimates.
Correlation Coefficient
The most common measure of "correlation" or "predictability" is Pearsons coefficient of correlation, although
there are certainly many others. Pearsons r, as it is often symbolized, can have a value anywhere between -1 and 1.
The larger r, ignoring sign, the stronger the association between the two variables and the more accurately you can predict
one variable from knowledge of the other variable. At its extreme, a correlation of 1 or -1 means that the two variables are
perfectly correlated, meaning that you can predict the values of one variable from the values of the other variable with
perfect accuracy. At the other extreme, an r of zero implies an absence of a correlation i.e., there is no relationship between
the two variables. This implies that knowledge of one variable gives you absolutely no information about what the value of
the other variable is likely to be. The sign of the correlation implies the "direction" of the association. A positive
correlation means that relatively high scores on one variable are paired with relatively high scores on the other variable,
and low scores are paired with relatively low scores. On the other hand, a negative correlation means that relatively high
scores on one variable are paired with relatively low scores on the other variable.
RESULTS AND CONCLUSIONS
This section presents the descriptive statistics, the results of regression analysis and correlation coefficient.
The interpretation of the empirical findings is also reported in this section. Finally, important conclusions about the results
of the study have been drawn.
Descriptive Statistics
Prior to start of formal analysis, we present descriptive statistics in Table 1. The table shows the information at the
level of the variables. Table 1 presents the mean, median, maximum, minimum and standard deviation for the variables.
Correlation Coefficient
To check for the possible multi-co-linearity among the independent variables, we calculate the Pearsons
co- efficient of correlations for the independent variables. Table 2 presents the results. As we can see from the table, the
multi-co-linearity problem is not too severe among the selected independent variables. However, the table sheds light on
56 Gurmeet Singh H

Impact Factor (JCC): 4.4251 Index Copernicus Value (ICV): 3.0
some interesting correlations. Capital Structure and Profitability are negatively correlated. As debt to equity ratio increases,
a firms profitability decreases. Next up, capital structure and degree of financial leverage are positively correlated.
Hence as the debt structure increases, so does the financial payable burden on the firms assets. Lastly, profitability and
financial leverage are negatively correlated. Thus as one increases, the other one decreases. So profitability is in negative
relation with both capital structure and degree of financial leverage, as proved by theory as well.
Regression Analysis
Using pooled regression technique, we ran the regression of the capital structure on the degree of financial
leverage and the profitability of the firm with the aim to investigate whether these two variables have significant
explanatory power. The estimated results are reported in Table 3.
It can be observed from the table that the estimated value of the R-squared is approximately 0.02. This implies
that the capital structure of the firm is very negligibly determined by the two said variables jointly. It shows that only 2%
of the variations in dependent variable (CS) are explained by the given two independent variables.
The value of F-statistic (0.54) shows the validity of the model. Its value is 0.54 which is below its probability
(F-statistic) value of 0.58. Thus the overall model is not good. The Durbin-Watson statistic (1.23) is also close to 2, which
implies that the successive values of estimated residuals are not dependent on each other. This means that there is evidence
to accept the null hypothesis that there is no autocorrelation problem in the estimated model.
Regarding the significance of individual variables, the empirical results show that the firms capital structure is
very significantly negatively associated with profitability. The P-value is 0.34, as can be seen from the table. This implies
that the null hypothesis (HO1: profitability has no significant impact on capital structure) is accepted at 1 percent level of
significance. Thus empirically, profitability does not affect capital structure and we do not find much evidence that this
relationship is statistically significant.
The table also accounts for a positive relationship between capital structure and financial burden of firm, as is
indicated by the co-efficient value (1.48). But taking the significance level of probability to be 0.1, the p-value of DFL was
found to be 0.96. This shows highly insignificant results, the second null hypothesis is accepted which states that degree of
financial leverage has no significant impact on capital structure
Henceforth, it can be concluded that though firms profitability is strongly negatively related to capital structure
and financial leverage positively, as was found earlier through Pearsons correlation coefficient, but statistically in the light
of p-value, both these findings were insignificant to establish any valid relationship of the two said independent variables
with the dependent variable of capital structure. Therefore, it can be safely said that in FMCG sector of India, profitability
and financial leverage of firms are insignificant in bringing about any changes in their capital structure.
REFERENCES
1. Fan, J. P. H., Titman, S., & Twite, G. (2010, September). An International Comparison of Capital Structure and
Debt Maturity Choices.
2. Frank, M. Z., & Goyal, V. K. (2003, April 17). Capital Structure Decisions.
Interrelation Between Capital Structure and Profitability of FMCG Companies of India 57

www.tjprc.org editor@tjprc.org
3. Frank, M. Z., & Goyal, V. K. (2007, October 10). Capital Structure Decisions: Which Factors are Reliably
Important?
4. Guney, Y., Ozkan, A., & Yalciner, K. Dynamic Capital Structure Decisions: Evidence from Firms in an Emerging
Economy. The Turkish Economy, pp. 149-171.
5. Hatfield, G. B., Cheng, L. T. W., & Davidson, W. N. (1994). The Determination of Optimal Capital Structure:
The Effect of Firm and Industry Debt Ratios on Market Value. Journal of Financial and Strategic Decisions, vol.
7, no. 3.
6. Hijazi, S. T., & Tariq, Y. B. (2006). Determinants of Capital Structure: A Case for the Indiai Cement Industry.
The Lahore Journal of Economics, 11:1, pp. 63-80.
7. Picu, A., Rotaru, A., & Covaci, B. Factors that Influence the Decision of the Capital Structure in Commercial
Company
8. Qian, Y., Tian, Y., & Wirjanto, T. S. (2007, February). An Empirical Investigation into the Capital-Structure
Determinants of Publicly Listed Chinese Companies
9. Shah, A., & Hijazi, T. (2004). The Determinants of Capital Structure of Stock Exchange-listed Non-financial
Firms in India. The India Development Review, 43: 4 Part 2, pp. 605-618.
10. Shah, A., & Khan, S. (2007, October). Determinants of Capital Structure: Evidence from Pakistani Panel Data.
International Review of Business Research Papers, vol. 3 no. 4 pp. 265-282.
11. Waliullah, & Nishat, M. (2008, August 25). Capital Structure Choice in an Emerging Market: Evidence from
Listed Firms in Pakistan.
12. Zubairi, H. J. Impact of Working Capital Management and Capital Structure on Profitability of FMCG Firms in
Pakistan.
13. Zubairi, H. J., & Rashid, A. Leverage, Size and Profitability: The Case of Pakistans FMCG Industry.
APPENDICES
Table 1: Descriptive Statistics

Capital
Structure
Profitability
Financial
Leverage
Mean 153.2434 0.092061 1.006875
Median 133.1000 0.113573 0.967753
Maximum 466.6000 0.360237 3.473118
Minimum 0.000000 -0.335779 0.145789
Std. Dev. 105.6824 0.137777 0.587475
Skewness 1.126558 -0.771186 2.147107
Kurtosis 4.187358 3.920189 9.093162
Jarque
Bera
14.32403 7.123330 122.7102
Probability 0.000775 0.028392 0.000000

58 Gurmeet Singh H

Impact Factor (JCC): 4.4251 Index Copernicus Value (ICV): 3.0
Table 2: Estimated Correlations between Variables

Capital Structure

Profitability

Financial Leverage

Capital Structure 1
Profitability -0.111194088 1
Financial Leverage 0.123224758 -0.25022828 1

Table 3: Regression
Variable Coefficient Std. Error t-Statistic Prob.
PROFITABILITY -109.7593 113.0820 -0.970616 0.3364
FINANCIAL LEVERAGE 1.484041 26.52040 0.055958 0.9556
C 161.8537 34.80173 4.650739 0.0000

R-squared 0.021287 Mean dependent variable 153.2434
Adjusted R-squared -0.017861 S.D. dependent Variable 105.6824
S.E. of regression 106.6220 Akaike info criterion 12.23140
Sum squared residual 568412.6 Schwarz criterion 12.34292
Log likelihood -321.1320 F-statistic 0.543762
Durbin-Watson stat 1.232182 Prob(F-statistic) 0.583954