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Reef Resources Assessment and

Management Technical Paper
ISSN: 1607-7393
RRAMT 2014- Vol. 40, 2014, 1

The Effect of Leverage on Cement Industry Profitability

Somayyeh Mahmoudi*
Department of Accounting, Hamedan Branch Islamic Azad University, Hamedan, Iran

Abstract
This study presents an empirical insight into the relationship between leverage and firm profitability .Short term debt to equity(STD/E)
and long term debt to equity (LTD/E)were considered as leverage variables .Firm profitability is measured using return on equity(ROE)
and return on assets (ROA).For this purpose 28 cement firms have been studied on Tehran Stock Exchange during the time period
2008-2011 and the regression model and descriptive have been used in order to test the hypotheses. The results suggested that there
was a significant and negative relationship between leverage and firm profitability.
2014 Published by RRAMT France Ltd.
Keywords: Leverage, profitability, capital Structure

1. Introduction
One of the most important reference theories in enterprises financing policy is the theory of capital structure and various
studies use capital structure theory to highlight the significance of debt financing. Capital structure of a firm is defined
by its leverage; that is a mix of debt and equity financing which is subject to different financial difficulties. One crucial
issue confronting managers today is how to choose the combination of debt and equity to achieve optimum capital
structure that would minimize the firms cost of capital and improves return to owners of the business. According to
previous studies, financial leverage affects cost of capital,ultimately influencing firmsprofitability and stock prices
(Higgins,1977; Miller,1977; Myers,1984)
The trade-off theory states that a firm selects how much debt finance and equity finance it needs to employ by
evaluating the costs and benefits of each type of finance. Certainly such preference is not contemporary it is rather
familiar to researchers and managers (Butters 1949). In this theory, the management of the firm must assess the different
types of costs and benefits of the optional leverage strategy and must aim at a level of debt to value, such level is depends
on establishing a balance between debt tax shields and costs of bankruptcy (Myers (1984)).
Leverage refers to the extent to which firms make use of their money borrowings (debts financing) to increase
profitability and is measured by total liabilities to equity. Firms that borrow large sums of money during a business
recession are more likely to default to pay off their debts as they mature; they will end up with high leverage and are
more likely end up with a potential risk of bankruptcy. On the contrary, the lower the firm's borrowings, the lower the
leverage, and the risk of bankruptcy will eventually be lower which signifies that business will continue operating.
Profitable firms can issue debt at low rates of interest since they are seen as less risky by the creditors; furthermore,
profitable firms are able to generate large earnings use a lesser amount of debt capital than firms that make little profit
(Titman and Wessels, 1988; Mazur, 2007; Rajan and Zingales, 1995; Abor, 2005). Additionally, profitable companies
are inclined to decrease information asymmetry to creditor, investors and interested users thorough the use of

Reef Resources Assessment and Management Technical Paper, Vol. 40, 2014, 1, pp. 673-676

profitability (Myers, 1984; Liaqat. A., 2011; Qureshi et al, 2012). Therefore, there is a relationship between leverage and
profitability (John and Williams, 1985; Liaqat. A., 2011; Tong and Green, 2005; Al-Najjar and Taylor, 2008; Mazur,
2007)
2. Research background and hypotheses derivation
Studies conducted by Bos and Fetherston,(1993), concluded that, capital structure affects both performance or
profitability and riskiness of firms. This believes has been held by earlier researchers such as Miller and Modigliani
(1963) and Titman and Wessel (1988).
Yoon and jang(2005)have studied the relationship between return on equity ( ROE),financial leverage and size of
firms in the restaurant industry .Research results suggest that at least during the test period firm size had a more dominant
effect on ROE of restaurant firms than debt use, larger firms earning significantly higher equity returns.
Abor (2005) in his study in Ghana has reported a significantly positive relationship between the ratio of short-term
debt to total assets and profitability but a negative association between the ratio of long term debt to total assets and
profitability.
Senior et al(2013)have examined the relationship of between leverage and firm performance . This study has shown
that during the study period leverage was very significant (at 0.05) in influencing or determining returns on equity,
return on assets and the operating profit of listed banks in Ghana.
Alkhatib(2012) in this study was set out to explain the impact of the explanatory variable used in the study (firm's liquidity,
size, growth rate, profit, and tangibility) on leverage in Jordanian industrial and services companies listed on the Jordanian
Stock Exchange. The results show that for both industrial and services sectors; there were no statistical significant
relationship. When the two sectors were separated, the results for the industrial sector revealed that liquidity and tangibly
have significant relationship with leverage, whereas the results for the services sector revealed that the growth rate,
liquidity, and tangibility have significant relationship with leverage.
Hence this study was aimed at contributing to the debate on leverage by examining the elationship between
leverage and profitability in the cement industry on Tehran stock exchange.
According to the results of research, the following a sumption is expressed:
H0: Cement firms profitability (Return on Assets (ROA), Return on Equity (ROE)) significantly depends on its leverage
structure
H1: Cement firms profitability (Return on Assets (ROA), Return on on Equity (ROE)) significantly does not depends
on its leverage structure
3. Research Methodology
3.1.Definition variable
Leverage on capital structure variables are considered as the independent variables. Profitability variables are
considered as a dependent variables of research.
3.2.Measuring variables
For simplicity, short term debt to equity (STD/E) and long term debt to equity (LTD/E) were considered as leverage variables.
Short term debt to equity (STD/E) is the first leverage ratio used in the study as one of the explanatory variables.
Short term debt or current liabilities
Short term debt to equity (STD/E) =
Equity

Long-term debt to equity is another explanatory variable used in the study to explain the mix of leverage structure.
Long term debt
Long term debt to equity (LTD/E) or D/E=
Equity

Firm performance is measured using two (2) variables namely: 1. Return on equity (ROE) 2. Return on assets .
The return on equity (ROE) is defined as the ratio of pre-tax profit to total equity capital.
Operating profit
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Reef Resources Assessment and Management Technical Paper, Vol. 40, 2014, 1, pp. 673-676
ROE=
Equity

The return on assets formula, sometimes abbreviated as ROA, is a companys net income divided by its average of
total assets.
Net Income
ROA=
Average Total Assets

The impact of leverage in the above sense on the two (2) mentioned performance metrics were assessed via the
following multiple regression models.
Model No. 1
Relationship between return on equity (Y1) and LTD/E, STD/E
Y1,i,t = i + 1X1,i,t + 2X2,i,t +ui,
Model No.2
Relationship between return on assets (Y2) and LTD/E , STD/E

Y,2i,t = i + 1X1,i,t + 2X2,i,t +ui,

3.3. Statistical Population
The population under this study could be defined as all the cement firms listed on Tehran stock exchange.Therefore the
population frame was the list of cement firms found on the Tehran stock exchange between the periods 2008 to 2011 , 28
cement companies listed on Tehran stock exchange.
4. Statistical Results
The result of the descriptive statistics summarized in the table below:
Table 1. Summary of Descriptive Statistics
Capital structure
STD/E
LTD/E
ROE
ROA

Mean
.8411
.6088
39.0907
19.8879

Std.Deviation
.49614
.66939
20.12147
13.79819

The results of statistical hypotheses test are summarized in the tables below:
Table 2. The results of significance coefficients test for the hypotheses(Regression Model 1)
Model
1 (Constant)

B
49.459

Std. Error
3.355

Beta

t
14.740

Sig.
.000

LTD/E

-14.490

2.569

-.482

-5.640

.000

STD/E

-1.840

3.466

-.045

-.531

.597

As the table above shows, for the relationship between LTD/E and ROE sig=0.00which is less than %5 thus there is
a significant and negative relation. but for STD/E sig=0.59 is high than %5 .It can be said that there is no significant
relation between STD/E and ROE in companies.
Table 3. The results of significance coefficients test for the hypotheses(Regression Model 2)
Model
2 (Constant)

B
34.528

Std. Error
1.857

Beta

t
18.597

Sig.
.000

LTD/E

-11.537

1.480

-.543

-7.795

.000

STD/E

-9.263

1.929

-.334

-4.801

.000

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Reef Resources Assessment and Management Technical Paper, Vol. 40, 2014, 1, pp. 673-676

As the table above shows, for the relationship between LTD/E and STD with ROA sig=0.00which is less than %5 thus
there is a significant and negative relation between LTD/E and ROA ,also there is a significant relation between STD/E
and ROA .
5. Conclusion And Implications For Future Study
This study investigated the relationship between financial leverage and firm profitability. Short term debt to equity
(STD/E) and long term debt to equity (LTD/E) were considered as leverage variables. Firm profitability is measured using
two variables namely return on equity (ROE) and return on assets(ROA).
Hypothesis test show that there is a significant and negative relation between leverage information and firm
profitability. The result from the descriptive statistics also showed that over the period under study cement companies
are highly levered and the performance of listed cement companies measured by returns on equity (ROE) and return
on assets (ROA) were 39%, 19% respectively. This suggests an average performance of listed cement companies in
Tehran during the study period.
This study could therefore be the burning desire of top management of every firm to make prudent financing decision
in order to remain profitable and competitive. Hence managers should know how and to what extent leverage
influences their performance.
This study is not free from limitations. This study only used one independent variable, financial leverage. Because
there are various factors affecting firms profitability and level of debt use besides these variables, in order to more
effectively investigate the relationship between firms level of debt use and their profitability inclusion of covariates
is recommended for future study. Also, there are many cement firms in this country ,However, only 28 cement
companies were included in this study because the statistical population in this survey include the companies listed on
Tehran stock exchange.
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