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«The Impact of Financial Structure, Financial Leverage and Profitability on Industrial Companies Shares Value (Applied Study on a Sample of Saudi ...»

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Research Journal of Finance and Accounting www.iiste.org

ISSN 2222-1697 (Paper) ISSN 2222-2847 (Online)

Vol.5, No.1, 2014

The Impact of Financial Structure, Financial Leverage and

Profitability on Industrial Companies Shares Value

(Applied Study on a Sample of Saudi Industrial Companies)

Dr. Abdallah Barakat

Associated Professor, Shaqra University, Saudi Arabia

E-mail: abdullah_barakat1@yahoo.com


The study aimed to investigate the effect of financial structure, financial leverage and profitability on industrial company’s value as a long term strategic analysis that helps the analyst in predicting future company’s value on the light of the mentioned variables in addition to external environment analysis.A sample was selected from Saudi industrial companies listed in Saudi Stock Market amounting Forty-six companies.The study used the brochures issued by Saudi capital market for four years during the period of 2009 – 2012. The study used a set of statistical methods to determine the effect of study variables that reflect the operational, financing and investment aspects on company’s value of the as an ultimate goal of increasing shareholder wealth. The study concluded that there is statistically significant direct relationship between two independent variables: return on equity and capital structure and the dependent variable represented by stock market price. However, there is weak and inverse relationship between financial leverage and stock value, and this relationship is not significant, so there is no statistically significant relationship between financial leverage and company’s value. There is a positive relationship between capital structure and return on equity upon using multiple regression analysis; it was shown that the strongest relationship was between capital structure and dependent variable (company’s stock value). Finally, there is a clear impact of financial structure return on equity on company’s value, and therefore by reviewing these variables the financial analyst can predict future company’s value.

Keywords: Financial Leverage, Financial Structure, Profitability, Stock Market Value, Company’s Value.

1. Introduction The primary objective of published financial statements is to provide interested parties with necessary and useful information for decision-taking. The company’s published analysis of financial statements in the current period and prior periods are considered as best method to estimate company’s future performance and assessment of its situation. The development that accompanied financial analysis upon the emergence of strategic analysis is considered one of the best methods to measure all company’s aspects, since analyst can measure all aspects of company's performance.He can after results evaluation extract valuable information about the effectiveness of company's operating, financing and investment policies, as well as strengths and weaknesses points, which require management attention to address problems which appear in evaluation process. Financial analyst strategic activity is not only limited on that, but it extends to include the development required strategies for the company, to obtain competitive advantage, that helps it in increasing its market share, thereby increasing profitability and fixed sustainable growth rate, which leads to increase its value which is the strategic goal of financial Management. Therefore, this study is to shed light on the importance (the impact) of the financial structure, financial leverage and profitability in company's value through studying the impact of these factors on a sample of Saudi Industrial Companies. The study has been divided to include the theoretical side of financial structure, financial leverage and profitability, the study importance, its objectives, methodology which included its problem statement, population. Sample, hypotheses, used statistical analysis, hypotheses testing, and finally results discussion and recommendations.

2. Study Theoretical Frame

Financial Structure:

Financial structure includes all items of liabilities and equity, while liabilities include liabilities are short-term and long-term liabilities, in other words, funds sources obtained by the company to finance its investments, whether short-term or long-term (Munir Ibrahim Hindi 1989), (Khalil Shama’a 1989). There is a must to differentiate between financial structure concept and capital structure, since capital structure means long-term (long-term liabilities + equity) funding sources, while financial structure (funding structure) includes (short-and long -term liabilities + equity) (Palepu, 2005). Company’s financial structure has a great importance in investment and financing decisions, due to its impact on profitability, as well as risk degree faced by the company due to its dependence and expanding on debt. Financial structure decisions Affect Company’s financial risk measured by leverage which is a ratio of borrowed to owned money 55 Research Journal of Finance and Accounting www.iiste.org ISSN 2222-1697 (Paper) ISSN 2222-2847 (Online) Vol.5, No.1, 2014

Financial Leverage:

Financial risks are linked with funding decisions; this means that it is linked with company selection of a combination of its financial structure. Financial leverage leads to high degree of risk faced by shareholders, so it increases the likelihood of its inability to service the debt. Therefore financial policy tries to harmonization between the impact of borrowing and the return on equity, as well as the degree of risk faced by shareholders.So it can be said that harmonization between debt and equity to conclude the optimal mix of financial structure that leads to reduce funds cost.

Financing decisions:

Each company works to determine its targeted financial structure parameters, in terms of its constituent elements and the proportion of each element in it. Through that it works to achieve its strategic objective represented by increase or maximize company‘s value.This requires that there should be a balance between the expected return, which resulted financial structure and the risks this return is subject to. Under ideal assumptions imposed by Modigliani and Miller for financial markets, the financing structure does not affect the capital cost and thus company’s value remains constant and is not affected by financing structure. However, due to debts privilege of tax advantage given that their interests are exempted from tax, the presence of debt in its financial structure reduces capital cost, which leads to increased profitability, thus increasing the return on equity which will reflect positively on increment of company’s value.

Financing Resources 1-Short-term financing:

The company needs short-term financing to finance its investments in working capital, which is a must for production and sales continuity. Short-term financing is defined as due debt obligations in a period of time less

than a year (Mohammed Ayman AlMaidani.1989), and is divided as follows:

• Commercial Credit, it is a short-term financing the company obtained from creditors, and is represented by futures procurement, and it may be without cost (free) or with cost.

• Bank credit.

• Dues which are delayed wages or taxes … etc, where the company can take advantage of the funds of these accounts in financing its short-term investments.

2-Medium-term financing:

It is a financing source of the permanent part of financing investments in working capital and additional financing for fixed assets, including loans -term (3-7 years) and machinery and equipment loans.

3- Long-Term Financing:

It is the supplementary part of financial structure, including property funds (shares retained earnings and reserves) and long-term borrowings (long-term loans + bonds)

Advantages and disadvantages of debt as a source of financing:

First, the advantages:

1-Financing by indebtedness is less expensive than financing by shares because of tax savings.

2-Fixed borrowing costs, and also cost of loan contracting and bonds issuance is less than the cost of issuing stock.

3-Lenders have no right to vote in Shareholders General Assembly.

4-Borrowing may hinder company flexibility and in particular if borrowing through bonds due to large undertakings (Covenants).

Second: Disadvantages:

1-Failure to pay interest or debt origin may lead to company bankruptcy.

2-Borrowing increases company’s financial risk.

3-Indebtedness constitute financial burdens on company because it has due date.

4-Some loans allow imposing restrictions on the enterprise and in the process of issuing bonds in particular.

5-Some companies may find it difficult to obtain long-term loans due to the difficulty of obtaining such loans.

Advantages and disadvantages of Financial Leverage: (Ahmad Ibrahim Farhana et al 1994)

First, advantages:

1- Financing by borrowing is less expensive than stocks financing because of tax savings that generated by, and due to borrowers exposure to risks relatively less than those shareholders face.

2- Borrowing cost re[resented by interest rate does not vary with profits level.

3- Investment in debt securities from investor’s viewpoint is less risky than stocks investments.

4- Borrowing by bonds allows the company to require right call, and this condition achieves company's flexibility in case interest rate is decreased in the market.

5- Cost of loans contracting and bonds issuance is less compared with cost of stock issuing

Second: Disadvantages:

1- financial leverage leads to increase company.financial risk 56 Research Journal of Finance and Accounting www.iiste.org ISSN 2222-1697 (Paper) ISSN 2222-2847 (Online) Vol.5, No.1, 2014 2- Loans maturities request the company to provide the necessary cash to pay it off in maturity.

3- The possibility of imposing restrictions on the company as a result of borrowing (Covenants) 4- Small companies face difficulty in obtaining long-term loans Profitability Company’s value depends on its revenue strength represented by its ability to make profits from sales (net profit margin), as well as its ability to invest in its assets to increase sales (assets turnover), and whenever the company is able to reduce its costs, whether sales cost, or general and administrative expenses, they will contribute in its profitability increment.

The company with high profitability from assets can detain greater part of its net annual profits to finance its needs and thus less dependence on debt, but by deducting debt interest expense (according Modigliani and Miller swap theory) (Mohammed Ayman AlMaidani, 1989), company value increased by debt ratio increment and this

value will be maximized by using the indebtedness under the following assumptions:

• lack of cost mediation in securities sale and purchase

• The absence of taxes on individual income.

• The possibility of borrowing with one interest rate either for individuals or companies.

• The same information is available to shareholders and company management of for future investment opportunities.

Therefore, company profitability is considered as an indicator of management efficiency, thereby increasing the demand for shares in the financial market by investors, which leads to increase the market value, therefore return on equity (ROE) was selected as an indicator of company profitability in this study.

3. Study General Framework:

This study is considered exploratory with respect to Saudi industrial companies, as well as correlation one because it is handles the relationship between financial structure, financial leverage, profitability and market value.

3.1 Study importance The study importance is due to its focused on investigating the impact of number of important variables in industrial company value in Saudi Arabia, which may help finance and investment decision makers in the Kingdom to increase the level of accuracy of their decision.

3.2 Problem of the study:

New financial management in joint-stock companies aims to maximize the company market value or to maximize stock value in the market.Achievement of to this goal depends on a number of variables that vary in its impact on company's value from one variable to another and from one market to another and from one sector

to another Therefore, the problem of the study is to answer the following questions:

1-Does company capital structure listed in Saudi financial market on its share price in the market?

2-Is there any effect of leverage degree in industrial companies listed on the Saudi financial market on their stock prices in the market?

3-Is there any effect of profitability of industrial companies listed in Saudi financial on their stock prices in the market?

3.3 Study Objectives:

Study objectives were determined as follows:

1-To investigate the relationship between financial structures of Saudi industrial companies and their stocks market price.

2-To identify the relationship between leverage degree of in Saudi industrial companies and their market value.

3-To identify the relationship between profitability of Saudi industrial companies and their stocks market price

3.4 Hypotheses

Based on study model the following hypotheses were formulated as follows:

The first hypothesis:

Ho: There is no effect of capital structure in Saudi industrial company’s stock price of in Saudi financial market.

The second hypothesis:

Ho: There is no effect of leverage ratio capital structure in Saudi industrial company’s stock price of in Saudi financial market

The third hypothesis:

Ho: There is no effect of profitability (return on equity) in Saudi industrial company’s stock price of in Saudi financial market.

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