Effect of Leverage (Operating and Financial) on Profitability of Chemical Sector of Pakistan

Abstract

Business is considered an economic engine for any country. It provides goods, services and income to the people and receives resources and revenues from them. This circular flow keeps the economy running and growing. In order to meet its expenses, a business needs investment in different forms. However, an investor will only invest in a business if he can earn good return for his investment with least amount of risk involved. Due to this fact, companies aim to maximize shareholders wealth. In order to achieve this primary goal, investment and financing decisions play an important role in the profitability of a company. These decisions gives rise to an important financial factor known as leverage. A lot of theoretical work is found which aims to explain the relationship of leverage and profitability. However, this research work does not provide one solution which can be applied to all economies and markets. The empirical research work done on this topic provides multiple examples of the fact, that in different economies and market segments the nature of this relationship is different. This creates a need to analyse this relationship in different environments to determine specific factors which effect it. This study aims to analyse the effect of leverage on profitability in the chemical sector of Pakistan. This sector has a lot of potential but has not received much attention from the government due to which its growth has remained slow. To determine the effect of leverage in the chemical industry the DOL, DFL and DCL values of 28 chemical companies have been calculated for the years 2007 – 2013. The effect of these factors is analysed by correlation and regression analysis on ROA, ROE and EPS. The results show that operating and combined leverage have positive relationship with the profitability, while the financial leverage has negative relation. However, none of these relationships are statistically significant. The results conclude that the leverage does not have a significant relationship with the profitability of the chemical industry of Pakistan and it cannot be used as tool to magnify profits. This is due to the high cost of raw materials and poor technology utilized in the industry to produce resource and labor intensive but low value added products. Moreover, chemical sector is still in a growing phase where a lot of companies are still establishing and need time for stable and financially strong operations.