Chapter II

REVIEW OF RELATED LITERATURE

This chapter presents the conceptual and research literature which provides

the foundation for the analysis and interpretation of the findings of the study.

Conceptual Literature

This part pertains to the literature from books and online sources which

were found relevant to the study.

Profitability

Conglomerates in the Philippines need to handle the flow of their funds

effectively to ensure their successful performance. They need to monitor as to

whether their funds are enough to support their operation. According to Ross,

Westerfield, and Jaffe (2012) one of the most difficult attributes of a firm is to

conceptualize and to measure profitability. In a general sense, accounting profits

are the difference between revenues and cost. Unfortunately, there is no

completely unambiguous way to know when a firm is profitable. At best, a financial

analyst can measure current or past accounting profitability. Many business

opportunities however involve sacrificing current profits for future profits. Another

problem in accounting-based measures of profitability is that they ignore risk. It

would be false to conclude that two firms with identical current profits were equally

profitable if the risk of one was greater than the other.

Accounting data are often used to analyze a firm’s financial conditions. Such

analysis may be conducted by creditors to measure the safety of their loans.

Investors also analyze financial statements to learn how well management is

 17

performing. In addition financial statements are analyzed to identify weaknesses

in the firm, which, if corrected, may increase the firm’s profitability and value.

Profit maximization is said to be the main objective of all firms. However,

according to Ross et.al (2012) the most important conceptual problem with

accounting measures of profitability is they do not give us a benchmark for making

comparisons. In general, a firm is profitable in the economic sense only if its

profitability is greater than investors can achieve on their own in the capital

markets.

An indication of good financial health and how effectively the firm is being

managed is the company’s ability to earn a satisfactory profit and return on

investment. Investors will be reluctant to associate themselves with an entity that

has poor earning potential since the market price of stock and dividend potential

will be adversely affected. Creditors will shy away from firms with deficient

profitability since the amounts owed to them may not be paid (Shim & Siegel,

2007). To eliminate these problems, firms measures the effectiveness of their

management through profitability ratios (Harina, 2011).

Further, McGuigan et.al (2009) explained profitability ratios as a ratio

measuring the effectivity of a firm’s management in generating profits on sales,

total assets and most importantly stockholders’ investment. Therefore anyone

whose economic interests are tied to the long-run survival of a firm will be

interested in profitability ratios. In addition, Finance 1 (2014) stated that profitability

ratios assist in evaluating various aspects of a company’s profit-making activities.

 18

It attempts to measure a company’s ability to earn an adequate return relative to

sales or resources devoted to operations. When calculating profitability ratios,

analysts often adjust net income for any transitory income effects.

Profitability ratios include net margin, return on assets, return on equity and

earnings per share. These ratios measure the overall efficiency of the firm in

managing its total investment in assets and in generating return to shareholders.

These ratios indicate the amount of profit earned relative to the level of investment

in total assets and investment of common shareholders (Cabrera, 2011).

Net Margin. Net margin, sometimes called operating margin, profit margin,

or the return on sales ratio, describes the percent of each sales dollar remaining

after subtracting other expenses other hat income tax expense. Finance 1 (2014)

explained return on sales ratio as a ratio which measures an important dimensions

of a company’s profitability. It indicates the portion of each dollar of revenue that

is available after all expenses have been covered. It offers a measure of the

company’s ability to withstand either higher expenses or lower revenues.

According to Shim and Siegel (2007) the ratio also provides clues to a company’s

pricing cost structure and production efficiency.

The profit margin is computed by dividing net income by sales. It expresses

net income (earnings) as a percentage of sales. Suppose two firms have identical

operations in the sense that their sales, operating costs, and operating income are

identical. However, one firm uses more debt; hence it has higher interest charges.

Those interest charges pull down its net income; and since sales are constant, the
 19

result is a relatively low profit margin for the firm with more debt (Brigham et.al,

2013).

Similarly, Brealy et.al (2015) stated that the profit margin ratio shows the

proportion of revenue that finds its way into profits. After all the bills are paid and

expenses covered, this ratio measures how much net profit remains out of each

dollar of sales. This ratio is important to calculate, but one needs to look at Gross

Profit Margin and Operating Profit Margin in order to analyze the big picture of how

well the company is doing.

According to Brealy et.al (2015), as to the other margin ratios, the higher

the net profit margin, the better. Taxes, interest, and expenses not associated with

operations will lower this ratio compared to the other margin ratios.

Another indicator of a firm’s profitability is earnings per share. It is based, in

part, on information not necessarily contained in financial statements – market

price per share of the stock. According to Ross et.al (2011) these measures are

obviously calculated directly only for publicly traded companies.

Return on Equity. Equity investors are typically concerned about the

amount of profit that management can generate from the resources that owners

provide. A closely watched measure that captures this concern is return on

shareholder’s equity (Finance 1, 2014). Return on Stockholders’ equity ratio

measures the profitability of the firm in generating return to shareholders. It is

defined by McGuigan et.al (2009) as the ratio measuring the rate of return that the
 20

firm earns on stockholders’ equity. Because only the stockholders’ equity appears

in the denominator, the ratio is influenced directly by the amount of debt a firm is

using to finance assets.

It would appear that financial leverage always magnifies ROE. This occurs

only when ROA (gross) is greater than the interest rate on debt (Ross et.al, 2012).

This ratio is usually higher than ROI because of financial leverage. As long as a

company’s ROI exceeds its cost of borrowing (interest expense), the owners will

earn a higher return on their investment in the company by using the borrowed

money.

Return on equity has some alternative name such as return on average

common equity, return on net worth, and return on ordinary shareholders’ fund

(Kieso, Weygandt, & Warfield, 2016). It can be computed by dividing the net

income to the average common stockholders’ equity (Ross et.al, 2012).

Return on Assets. One of the key ratios in measuring the profitability of a

business enterprise is the return on asset ratio. According to Finance 1 (2014),

return on assets (ROA) ratio expresses income as a percentage of the average

total assets available to generate that income. Because total assets are partially

financed with debt and partially by equity funds, this is an inclusive way of

measuring earning power that ignores specific sources of financing.

Return on asset indicates the efficiency with which management has used

its available resources to generate income (Shim & Siegel, 2007). A company’s
 21

ROA is related to both profit margin and asset turnover (Finance 1, 2014). It is the

ratio of wealth generated (net income) to the amount invested (average total

assets) to generate wealth. ROI can be computed using the formula of net income

over average total asset

One of the most interesting aspects of return on assets is how some

financial ratios can be linked together to compute ROA. DuPont system of financial

control is a system that highlights the fact that ROA can be expressed in terms of

the profit margin and asset turnover margin. Firms can increase ROA by increasing

profit margins or asset turnover. Of course, competition limits their ability to do so

simultaneously (Ross et.al, 2012).

Investors and creditors use profitability ratios to judge as to whether firms

are making enough operational profit from their sources. Another method that

investors and creditors consider when judging how profitable a business enterprise

is by calculating its profit margin ratio.

Earnings per share is the reward of an investor for making his investment

and it is the best measure of performance of a business entity. Ordinary investor

lacking in depth knowledge and inside information mainly based on ESP to make

their investment decision. So it should be the objective type of a financial

management to maximize the EPS from the viewpoint of both the investor and

investee (Cabael, E. et al., 2008).

 22

Earnings per Share. Earnings per share is defined as the company’s profit

allocated to each outstanding equity share. The profits used to calculate EPS are

the profits that are left after paying interest to debt holders, taxes and dividend on

preference shares. EPS is considered to be a key figure in evaluating a share’s

outlook (Horne et.al 2008).

Stockholders are generally not concerned with total earnings but with

earnings per share. Mayo (2015), presented that the bottom line of the income

statement shows the earnings per share, which is net earnings divided by the

number of shares outstanding. This is the amount of earnings available to each

share of common stock.

In addition, Salvador et. al (2012) further elaborated EPS as the ratio most

widely watched by investors. It shows the net income per ordinary share owned;

rate determined by reducing net income by the preference share dividends. If

preference share is not part of the business enterprise’s capital structure, EPS is

determined by dividing the net income by ordinary shares outstanding. EPS is a

gauge of corporate operating performance and of expected future dividends.

Financial Leverage

According to McGuigan, Kretlow, and Moyer (2009) both long- and short-

term creditors are concerned with the amount of leverage a business enterprise

employs because it indicates the company’s risk exposure in meeting debt service

charges (that is, interest and principal repayment). A company that is heavily
 23

financed by debt offers creditors less protection in the event of bankruptcy. Owners

are interested in financial leverage because it influences the rate of return they

expect to realize on their investment and the degree of risk involved.

Financial analysts makes used of financial ratios to make a comparison of

a company’s financial condition over time or in relation to other firms. McGuigan

et.al (2009) explained financial leverage management ratio as a ratio indicating a

firm’s capacity to meet short and long term debt obligations. Either balance sheet

or income statement data can be used to measure a firm’s used of financial

leverage. The balance sheet approach gives a static measure of financial leverage

at a specific point in time and emphasizes total amounts of debt, whereas the

income statement approach provides a more dynamic measure and relates

required interest payments on debt to the firm’s ability to pay. Both approaches are

employed widely in practice.

Financial leverage indicates the reliability of a business on its debts in order

to operate. Knowing about the method and technique of calculating financial

leverage can help in determining business’ financial solvency and its dependency

upon its borrowings. According to Smith (2009), financial leverage is commonly

explained as the use of borrowed money to make an investment and return on that

investment. In addition, McGuigan et.al (2009), stated that whenever a company

finances a portion of asset with any type of fixed-charge financing--such as debt,

preferred stock, or leases—the firm is said to be using financial leverage. Thus,

the more debt a firm has, the more likely it is that the firm will become unable to
 24

fulfill its contractual obligations. In other words, too much debt can lead to a higher

probability of insolvency and financial distress (Ross, Westerfield, & Jaffe, 2012).

Leverage ratios include the overall dependence of the company on outside

creditors relative to stockholder and internal financing. The question of long term

financing risks concern both stockholders and creditors because debt caries a

contractual obligations, in extreme cases, can lead to threats of bankruptcy

(Saldaña, 2008).

According to previous studies, financial leverage affects cost of capital,

ultimately influencing firms’ profitability and stock prices. Several researchers have

studied the firms’ debt use and suggested the firms’ debt-equity decision is

generally based on a trade-off between interest tax shields and the costs of

financial stress (Upneja & Dalbor, 2009)

If a business fails and must be liquidated, the claims of creditors take priority

over those of the owners. But if the business has a great total debt, there may not

be enough to make full payment to all creditors. A basic measure of the safety of

creditors’ claims is the debt ratio, which states total liabilities as percentage of total

assets. (Peterson, 2011).

As the firm operates in a going concern manner, it has to ensure that the

firm will meet not only its short term obligation but also its long term debts.

According to recent studies conducted by My Accounting Course, solvency ratios,

also called leverage ratios, measure a company's ability to sustain operations

indefinitely by comparing debt levels with equity, assets, and earnings..

 25

Debt to Equity. The debt/equity ratio is similar to the debt ratio and relates

the amount of a firm’s debt financing to the amount of equity financing. Cabrera

(2011) explained debt to equity ratio as a ratio measuring the riskiness if the firm’s

capital structure in terms of relationship between the funds supplied by creditors

(debt) and investors (equity). According to Cabrera the amount and proportion of

equity and debt in a company’s capital structure are extremely important to the

financial analyst because of the trade-off risk and return. While debt implies risk, it

also provides the potential for increased benefits to the firm’s owners.

The debt/equity ratio is a significant measure of solvency since a high

degree of debt in the capital structure may make it difficult for the company to meet

interest charges and principal payments at maturity. Further, with a high debt

position comes the risk of running out of cash under conditions of adversity. Also,

excessive debt will result in less financial flexibility since the company will have

greater difficulty obtaining funds during a tight money market (Shim & Siegel,

2007). This is because the higher ratio indicates more financial risk because it

indicates the company is relying more heavily on debt financing (Anonymous, n.d.).

Similarly, Shaun (2009) described that creditors view a higher debt to equity

ratio as risky because it shows that the investors haven't funded the operations as

much as creditors have. In other words, investors don't have as much skin in the

game as the creditors do. This could mean that investors don't want to fund the

business operations because the company isn't performing well. Lack of

 26

performance might also be the reason why the company is seeking out extra debt

financing.

Given the following explanation, McGuigan et.al (2009) contends that the

debt to equity ratio, in actuality, is not really a new ratio. It is simply the debt ratio

in a different format. The debt/equity ratio is similar to the debt ratio and relates

the amount of a firm’s debt financing to the amount of equity financing.

An analysis by Saldaña (2008) stated that the debt to equity ratio identifies

the financing group with the greater interest in the long term viability of the

company. If the ratio does not exceed one, then the stockholders remain the

majority contributor of long term funds whereas if the ratio exceeds one, then the

creditors have the greater exposure, in financial terms. The ratio is therefore a

good indicator of which group has the greater representation in the assets of the

company. In extreme cases where the debt-equity is a large number, the company

is said to be “highly leveraged” and in face of major decisions like threats of

bankruptcy, the creditors are often observed to take extraordinary steps to protect

their interest.

If a business fails and must be liquidated, the claims of creditors take priority

over those of the owners. But if the business has a great total debt, there may not

be enough to make full payment to all creditors. A basic measure of the safety of

creditors’ claims is the debt ratio, which states total liabilities as percentage of total

assets (Bettmen, Carcello, Haka, & Williams, 2015).

 27

Debt to Asset. Debt to asset ratio helps investors and creditors in the

analysis of the overall debt burden on the company as well as the firm's ability to

pay off the debt in future. Cabrera (2011) defined debt to asset ratio as a ratio

measuring the proportion of all assets that are financed with debt. It is calculated

by dividing the total debt by total assets (Ross et.al, 2012).

According to Shim and Siegel (2007), this ratio compares total liabilities

(total debt) to total assets. It shows the percentage of total funds obtained from

creditors.

Generally, the higher the proportion of debt, the greater the risk because

creditors must be satisfied before the owners in the event of bankruptcy. The use

of debt involves the risk because debt carries a fixed obligation in the form of

interest charges and principal repayment. Failure to satisfy the fixed charges

associated with debt will ultimately result in bankruptcy (Cabrera, 2011).

McGuigan et.al (2009) further elaborated debt ratio as a term encompassing

all short-term liabilities and long-term borrowings. Bondholders and other long-

term creditors are among those likely to be interested in a firm’s debt ratio. They

tend to prefer a low debt ratio because it provides more protection in the event of

liquidation or some other major financial problems. As the debt ratio increases, so

do a firm’s fixed-interest charges. If a debt ratio becomes too high, the cash flow a

firm generates during economic recessions may not be sufficient to meet the

interest payments. Thus, a firm’s ability to market new debt obligations when it

needs to raise new funds is crucially affected by the size of the debt ratio and by
 28

investors’ perception about the risk implied by the level of ratio. A high debt ratio

implies a low proportionate equity base, that is, the percentage of assets financed

with equity funds. As the proportionate equity base declines, investors are more

hesitant to acquire a firm’s debt obligation.

Further, Brigham (2013) explained that creditors prefer debt ratios because

the lower the ratio, the greater cushion against creditors’ losses in the event of

liquidation. Stockholders, on the other hand, may want more leverage because it

can magnify expected earnings.

Times Interest Earned. In addition to the ratios previously covered, Mayo

(2015) stated that financial analysts may compute coverage ratio, which indicate

the ability of the firm to service some payment, such as interest. All coverage ratios

consider the funds available to meet a particular expense relative to that expense.

They relate the financial charges of a firm to its ability to service, or cover them.

Interest coverage or commonly known as Times Interest Earned ratio

emphasizes the ability of the firm to generate enough income to cover interest

expense. Interest expense is an obstacle that a firm must surmount if it is to avoid

default. The ratio is directly connected to the ability of the firm to pay interest (Ross

et al,)

Brigham et. al (2012) explained times-interst-earned ratio as one that

employs income statement data to measure a firm’s use of financial leverage. It

 29

tells an analyst the extent to which the firm’s current earnings are able to meet

current interest payments.

According to Anastacio et al. (2010), this ratio indicates the ability of the firm

to pay fixed interest charges. It gauges the company’s ability to protect long-term

creditors.

The ratio of interest coverage is calculated by dividing earnings before

interest and taxes by interest. The numerator uses operating income (EBIT), since

interest is paid after other expenses but before taxes. The higher the numerical

value of the ratio, the greater the likelihood that the company could cover its

interest payments without difficulty. It also sheds some light on the firm’s capacity

to take on new debt (Mayo, 2015).

Horne et. al (2008) further elaborated the ability to cover interest expense

is important, for failure to meet interest payments as they come due may throw the

firm into bankruptcy. Deterioration in the times-interest-earned ratio gives an early

warning to creditors and investors, as well as to management, of a deteriorating

financial position and an increased probability of default on interest payments.

In an observation conducted by Wald (2011), highly profitable firms implies

lower levels of leverage than less profitable firms because they first use their

earnings before seeking outside capital. Firms tend to issue equity rather than

use debt when their stock price increases, so that their leverage levels stay

lower than firms using debt. In general, business firms like San Miguel Corporation

needs to handle the flow of their funds effectively to ensure that their financial
 30

performance is successful. They need to monitor as to whether their funds are

enough to support their operation.

San Miguel Corporation also known as SMC, together with its subsidiaries

which are collectively referred to as SMC Group, is one of the largest and most

diversified conglomerates in the Philippines by revenues and total assets, with

sales of about 6.2% of the Philippine gross domestic product in 2014. The

company makes a considerably extensive dispersion organize for their items and

extend their client base by recognizing cooperative energies over their different

organizations. Likewise, they are seeking after plans to incorporate their creation

and appropriation offices for both their set up and recently procured organizations

to produce extra cost reserve funds and efficiencies.

Originally founded in 1890 as a single brewery in the Philippines, SMC has

transformed itself from a market-leading beverage, food and packaging business

with a globally recognized beer brand, into a diversified conglomerate with market-

leading businesses and investments in the fuel and oil, energy, infrastructure,

telecommunications and banking industries. SMC owns a portfolio of companies

that is tightly interwoven into the economic fabric of its home market, benefiting

from and contributing to the development and economic progress of the

Philippines. The common shares of SMC were listed on November 5, 1948 at the

Manila Stock Exchange, now The Philippine Stock Exchange, Inc.

In 2007, in light of the opportunities presented by the global financial crisis,

the ongoing program of asset and industry privatization of the Philippine

 31

government, the strong cash position of SMC enhanced by recent divestments and

the strong cash flow generated by its established businesses, SMC adopted an

aggressive business diversification program. The program channeled the

resources of SMC into what it believes were attractive growth sectors, aligned with

the development and growth of the Philippine economy. SMC believes this strategy

will achieve a more diverse mix of sales and operating income, and better position

for SMC to access capital, present different growth opportunities and mitigate the

impact of downturns and business cycles.

Since January 2008 up to the third quarter of 2015, SMC has either directly

or through its subsidiaries, made a series of acquisitions in the fuel and oil, energy,

infrastructure, telecommunications and banking industries.

Research Literature

This section contained all related literature that the researchers derived

from various books and online gathering. The researchers considered other

resources and previous studies, both local and foreign that takes part in the

completion of the data needed in this study. The data found were carefully

examined to find similarities or relevance to the present study.

A study entitled “The Effect of the Financial Leverage on the Profitability in

the Tourism Companies (Analytical Study- Tourism Sector- Jordan)” conducted by

Al-Shamaileh and Khanfar (2014), aimed to identify the financial leverage ratio

and the rate of return on investment on profitability for sources of the funding in

tourism companies operating in Jordan, to ascertain the impact of the financial

Leverage and the rate of return on investment on profitability in the tourism

 32

companies operating in Jordan and to identify the impact of the cost of funding on

the rate of return on investment and profitability in the tourism companies operating

in Jordan. Using return on investment and other leverage ratios as their

independent variable similar with that of the present study. The study revealed

that there is no statistically significant relationship between the cost of funding by

Equity and profitability for the companies of the tourism sector in Jordan.

Furthermore, the results indicate the presence of a statistically significant impact

for the financial leverage on the profitability of the Tourism companies listed in the

Amman Exchange.

Al-Otaibi (2015) in his thesis, “Impact of Financial Leverage on the

Company’s Financial Performance”, concluded that there is a positive relationship

between the debt ratio and ROE, meaning that the financial leverage negatively

affect one of the measures of performance. In this study, the independent variable

is the debt to asset ratio, while the profitability ratios, return on equity and return

on asset, are the dependent variables. As the research aims to investigate the

impact of financial leverage on the performance of the Saudi firms listed in Saudi

stock exchange. Quantitative methods have been conducted, to discover the

nature of the relationship between financial leverage and the profitability

measures. The study used statistical methods that include regression analysis,

while having a sample that was gathered from the Saudi stock exchange for a

period of two years, having debt ratio as independent variable representing

financial leverage & ROA and ROE as dependent variables representing the

performance Al-Otaibi (2015).

 33

The study made by Tianyu He (2013) entitled “Comparison of Impact from

Capital Structure to Corporate Performance between Chinese and European

Listed Firms.”, encompasses 2 developed countries (Germany and Sweden) and

a developing country (China) to test the impact from capital structure to firm

performance of period 2003-2012 with more than 1200 listed companies in

Germany and Sweden and more than 1000 listed companies in China. The

researcher stated that it is not difficult to measure the firm performance and capital

structure; there are many different variables in economics to refer to them. For

example, rate on equity, EVA and profitability to measure firm’s performance, and

long-term debt ratio, short term debts ratio, asset liability ratio, biggest

shareholders of the enterprise and so on to measure capital structure. The results

showed that capital structure has a significant negative effect to firm performance

in China, whereas, significant positive effect in 2 European countries before

financial crisis happened in 2008. It is also concluded that institutional factors and

economic crisis will affect this relationship too.

Similar study conducted by Koech (2013) which is entitled “The Effect of

Capital Structure on Profitability of Financial Firms Listed at Nairobi Stock

Exchange” sought to investigate the effect of capital structure on profitability of

financial firms listed at Nairobi Stock Exchange during the period 2008-2013.

Koech and Tianyu both used regression analysis as one of the methods in their

study. Regression analysis is the statistical approach to forecasting change in

a dependent variable on the basis of change in one or more independent

variables. Relationships depicted in a regression analysis are, however,

 34

associative only, and any cause-effect inference is purely subjective. It can be

postulated that capital structure choice among listed financial firms support the

pecking order theory that firms prefer raising capital, first from retained earnings,

second from debt, and third from issuing new equity. The study of Koech

assessed that capital structure is inversely related to performance as revealed by

the regression results of debt and return on equity. Thus, it is shown that an

increase in the level of debt finance increases the interest payments and resulted

in a decline in profitability.

The population of the Industrial Jordanian shareholding companies listed in

the first and second markets in Amman Stock Exchange for the study period (2006-

2012) are the respondents of the study “The Relationship between Capital

Structure and Profitability” conducted by Shubita and Alsawalhah in 2012. The

study seeks to extend findings of the recent studies regarding the effect of capital

structure on profitability by examining the effect of capital structure on profitability

of the industrial companies listed on Amman Stock Exchange during a six-year

period. Capital Structure was defined as the mix of debt and equity that the firm

uses in its operation. The capital structure of a firm is a mixture of different

securities. In general, firms can choose among many alternative capital structures.

Applying correlations and multiple regression analysis, the study results revealed

significantly negative relation between debt and profitability and suggests that

profitable firms depend more on equity as their main financing option. These

findings imply that an increase in debt position is associated with a decrease in

profitability; thus, the higher the debt, the lower the profitability of the firm.
 35

Moreover, in the “Analysis on the effect of Financial Leverage on the

Profitability Performance of XYZ Corporation for the years 1998-2007” offers the

highest degree of relevance in the present study. The financial leverage ratios

measured by debt ratio, debt-equity ratio and debt to total capital ratios showed an

upward trend from 1998 to 2007. The increase on the said ratios are caused by

the continuous increase in liability each year. Times interest earned ratio however

drastically fall from 2002-2003 because of the negative earnings of the company

but recovered in 2007 onwards. The profitability of the corporation is not high but

it is increasing as debt increases. Positive correlations between the measure of

financial leverage and measures of profitability showed a low positive relationship.

As debt ratio, debt-equity ratio and debt to total capital ratio increases the

profitability measure also slightly increases. Times interest earned ratio and

profitability resulted to a very high positive relationship. As times interest earned

ratio increases, ROE, EPS, ROA and ROS also increased (Gonzales, Gutierrez,

& Magsino, 2008).

Another study assessed profitability and financial leverage. Raya (2009) in

his study entitled “Concentration Ratios, Financial Leverage and Profitability: The

Case of Selected Philippine Corporations 1998 – 2008”, stated that studies on the

empirical relationship between market share and profitability have focused largely

on operating profitability, with little attention to the contribution of financial leverage

or financing-related profitability. incorporated the two variables with concentration

ratios. The study was conducted to emphasize not just the empirical relationship

between market share and profitability which have focused largely on operating
 36

profitability, with little attention to the contribution of financial leverage or financing-

related profitability.

Further, a study “Relationship of Capital Structure with the Profitability of

Limcoma Multipurpose Coop. March 2011” focused on analyzing the components

of the capital structure of Limcoma. They incurred their primary data through an

interview with current financial manager of Limcoma MPC. The secondary data

were the audited financial statements, books, journals, unpublished materials, and

the internet. The study concluded that Limcoma’s capital structure is more of debt

rather than members equity. The cooperative was still able to generate minimal

cash from the contribution of the member equity but not enough to finance the

working capital. They have expanded the business and acquired huge amount of

inventories to support such additional project which are being financed through

debt financing. However the recorded decrease in Limcoma’s net income was due

to the decrease in net sales with increase in financial charges due to hug

borrowings. As debt to equity increases, the profitability of Limcoma in terms of

ROA, EPS and ROE decreases. On the other hand as debt asset increases ROE,

EPS and ROA decreases (De Castro, Magtibay, Maralit, & Reyes, 2011).

Tan, Chua, and Salamanca (2015) in the “Study of the Overall Impact of

Financial Leverage and Other Determinants of Systematic Risk” To estimate betas

as a measure of systematic risk for the frequently-traded non-financial firms listed

in the Philippine Stock Exchange; aimed to determine if there is a significant link

between the four measures of financial leverage and systematic risk, to identify the

different impacts of the alternative measures of financial leverage to the systematic

 37

risks of actively-traded non-financial firms listed in the PSE, and to to identify

whether or not there are significant differences among the financial leverage-

systematic risk relation in various sector classifications. The researchers

investigated the relationship financial leverage and systematic risk using the

dataset of 50 non-financial frequently-traded publicly-listed companies in the

Philippine Stock Exchange (PSE) from years 2007 to 2013. The findings showed

that most measures of financial leverage have a significant relationship with

systematic risk. The researchers included profitability and financial leverage as

variables which are similar with that of the current study.

In a study by Hernandez, Magpantay, Masula, and Silva (2008) entitled

“The Relationship of the Profitability and Leverage of Petron Corporation to its

Credit Rating for the years 2006-2008” concluded that Petron profitability is

decreasing because of the company’s net loss. The corporation’s leverage is

increasing yearly and it is bad for the company because there is a tendency that

the company would be bankrupt if their liabilities will still increase in the succeeding

years. The Petron Corporation has credit rating of PRS AAA for the three year

period. It is the highest rating that was given by Philratings. This was givwen based

on the financial and business risk of the company. The null hypothesis if no

relationship between credit rating and Petron’s profitability and leverage could

neither be rejected nor accepted which cannot be correlated because the credit

rating is constant all through the three year period.

The study made by Fabregas, et. al. (2005) entitled “An Assessment of

OEPI’s Financial Condition through Financial Statement” focused on the

 38

assessment of financial data through the use of secondary data . They conducted

time series analysis for the past five years of the company’s operation. They found

out that good pricing strategy is accountable for increases in the net profit margin.

They recommended that net profit margin could still have potential increase

through good control of operating expenses. In addition, the study revealed that

the shareholders themselves financed most of the company’s resources, thus, no

amount of leverage is maintained. However, although this is the case, return on

equity still reflected an impressive performance of the company mainly due to

performing ROA.

Synthesis

For further understanding of research basic, the researchers gathered

information from various related studies which are relevant in the current study.

Previous studies examined the effect of financial leverage on the

performance of the firms. Suggesting a negative relationship between the financial

leverage & the performance of the firms, because an increase in the level of

financial leverage increases the finance cost, hence the profitability of the firms

decreases because of the relatively increased interest payments. One the other

hand, other studies that has been conducted on the subject showed a positive

relationship between financial leverage & the performance of the firms.

The study of Al-Otaibi suggested that financial leverage positively affects

profitability. “Impact of Financial Leverage on the Company’s Financial

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Performance” concluded that employing a high level of debt may lead to an

increase in the profitability level of Saudi firms.

Likewise, the thesis conducted by Al-Shamaileh is similar to the current

study. The researcher used financial leverage, profitability and return on

investment as variables. The results indicated the presence of a statistically

positive significant impact for the financial leverage on the profitability of the

Tourism companies listed in the Amman Exchange.

On the other hand, the studies made by Koech and Tianyu He used capital

structure as variable. Both studies concluded that capital structure is inversely

related to firms’ performance. Koech also stated that factors such as amount of

debt, the risks associated with indebtedness, interest rates and debt equity

combination could affect the financial performance of firms.

In addition, the study of Shubita revealed the significantly negative

relationship between debt and profitability. These findings imply that an increase

in debt position is associated with a decrease in profitability; thus, the higher the

debt, the lower the profitability of the firm. It is also recommended that firm must

consider using an optimal capital structure which includes some debt but not 100%

debt.

Meanwhile, the study of Tan et al. suggested to have further studies to verify

the results obtained in their research paper. They introduced new variable. The

study shows that most measures of financial leverage have a significant

relationship with systematic risk. The researchers stated that one of the widely
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used indicator of systematic risk among firms is financial leverage, which means

that the more debt the firm has, the greater risk that it has acquired.

As an additional in the discussion of variables, the study conducted by Raya

is included in the research literature. It had been pointed out that measuring profit

as return on sales (ROS), rather than return on investment (ROI), understates

profits and the magnitude of the market share - profitability relationship. Also, he

found that market share – profitability findings differ when the measure of

profitability used is return on investment (ROI), return on assets (ROA) or return

on equity (ROE).