AN ANALYTICAL STUDY ON CAPITAL STRUCTURE AND ITS IMPACT ON PROFITABILITY

Abstract

The availability of finance is one of the key factors that affect companies in the long term. One of the most discussed topics in corporate finance is capital structure, or the proportion of debt to equity a business uses. The question of leverage and its effect on profitability continues to be debated. The leading theories have very different explanations, and sometimes contradict each other regarding the empirical evidence. For example “the Trade-off Theory suggests that firms seek an optimal debt-to-equity ratio that balances the advantages of debt with its disadvantages at higher debt levels. From this perspective, it is argued that companies with higher profits tend to have higher leverage Kebewar (2012). There is, however, a large literature that confirms this theoretical prediction, yet many studies have found a negative and/or non-significant leverage-profitability correlation. The Pecking Order Theory explains these conflicting observations by the extent of information asymmetry between insiders and the market, which determines the source of finance. Retained earnings are the most readily available source of finance, so firms with significant financing needs and, therefore, those that have to turn to external finance are likely to be less profitable. However, the debt ratio would increase during periods of financial constraint, thereby severing the relationship between leverage and profitability observed in the present study Aishwarya et al. (2022). Using alternative econometric approaches on quarterly panel data of listed construction companies from Eurozone economies, the study investigates the relationship between companies' capital structures and their corporate profitability for the period 2000-2023. The financial debt-to-equity ratio is a measure of capital structure in the long term. Meanwhile, firm profitability is indicated by return on investment (ROI), which is net operating income divided by total assets. A positive, significant relationship between leverage and profitability emerges, as predicted by the Trade-off Theory and as evidence that the benefits of leveraged tax shields outweigh the costs of financial distress. The study also shows that the findings are stable across various model specifications, estimation methods, and samples; explores non-linear relations; tests for lagged effects; and incorporates transaction-level characteristics, providing valuable new micro-level evidence for the debate on the determinants of corporate profitability. Analysis results support the general belief that an appropriate level of financial debt enhances firms' profits