SIZE AND OTHER DETERMINANTS OF CAPITAL

STRUCTURE IN SOUTH AFRICAN MANUFACTURING LISTED COMPANIES

By:

NOSIPHO MGUDLWA

DISSERTATION

Submitted in partial fulfilment of the requirements for the

MASTER OF TECHNOLOGY IN COST AND

MANAGEMENT ACCOUNTING

(MTECH: CMA)

at the

NELSON MANDELA METROPOLITAN UNIVERSITY

SUPERVISOR: PROF. P PELLE

Submission: November 2009

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DECLARATION: I, the undersigned, hereby declare that the work contained in this thesis is my own original work and that I have not previously, in its entirety or in part, submitted it at any university for a degree. ---------------------------------- ------------------- Signature Date

ii

ACKNOWLEDGEMENTS I wish to express my sincere thanks and gratitude to the following

people:

Prof. Pieter Pelle for his professional supervision and guidance

during the study.

My colleagues Chris Mkefa and Stanley Sithole for their

assistance and valuable support.

My son, Bantu, for his encouragement and love.

My family and friends for their encouragement, understanding

and support.

Last but not least to the Almighty for giving me the strength to

carry on.

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ABSTRACT The importance of the capital structure as a measure of company growth and

performance has been at the core of vigorous debate for many years. With the

threat of the recession and global competitiveness to the survival of

organizations, what constitutes an optimal capital structure had to be

interrogated. The focus of the study is to investigate the factors (with more

emphasis on size) that influence the capital structure of manufacturing firms in

general and South African manufacturing firms in particular. The aim is to

advance recommendations on policy formulation so as to improve the financial

performance of the manufacturing sector in South Africa, a developing economy.

The study is explained within the theoretical framework which relates elements

purported to have an influence on the capital structure to the use of leverage/debt

by organizations. Leverage is seen to increase the shareholders‟ interest whilst

being exposed to financial risk. The size of the organizations as a comparative

element defines the extent of accessing the borrowed funds, hence the

distinction between the Small, Medium and Micro Enterprises (SMMEs) and large

sized enterprises (LSEs). The research evidence indicates that SMMEs are

characterized by lower liquidity, use more short-term debt instead of use of long-

term debt, and are generally low in debt and basically capital intensive. On the

contrary LSEs are highly leveraged.

The selected research design is triangulated, with a combination of a case study

which is of a qualitative and interpretive nature, as well as a quantitative type

survey by means of a structured questionnaire. Twenty five ratios were

computed from information derived from the financial statements of organizations

and means and medians were determined for comparative reasons. The

questions were directed to chief financial officers or managers responsible for the

compilation of the financial statements, mainly to expand on the debt policy of

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their respective organizations. The findings confirmed the correlation between

gearing and size, asset structure and growth with the exception of profitability.

On the relevance of financial policy regarding debt, two factors were proven to be

influential to capital structure decisions: the theory and practice of capital

structure and the impact of the debt policy, both of which relate to financial

flexibility. The study concluded that as much as there are

similarities/consistencies between the two size groups, there are fundamental

differences confirming that size significantly impacts on the capital structure

choice specifically the use of debt. It is, therefore, recommended that the South

African government should review its policies with regards to the financial support

towards SMME viability.

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TABLE OF CONTENTS DECLARATION ACKNOWLEDGEMENTS ABSTRACT

PAGE NO.:

CHAPTER 1: INTRODUCTION AND RESEARCH METHODOLOGY

1.1 INTRODUCTION 4

1.2 AIM OF THE STUDY 7

1.3 RESEARCH METHODOLOGY

1.3.1 Research approach and design 8

1.3.2 Sample and data collection 8

1.3.3 Methodology 9

1.3.4 Data 10

1.3.5 Measurement 12

1.3.6 Analysis 12

1.4 RESEARCH STRUCTURE

1.4.1 Chapter 1: Introduction and Research design 13

1.4.2 Chapter 2: Literature review 14

1.4.3 Chapter 3: Findings 14

1.4.4 Chapter 4: Recommendations and Conclusions 14

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PAGE NO.:

CHAPTER 2: THEORETICAL FRAMEWORK AND LITERATURE REVIEW

2.1 INTRODUCTION 15

2.2 CAPITAL STRUCUTRE VS FIRM VALUE 15

2.3 KEY THEORETICAL CONCEPTS

2.3.1 Capital Structure 17

2.3.2 Weighted Average Cost of Capital 18

2.3.3 Leverage (debt) ratio 20

2.4 LITERATURE ON CAPITAL STRUCTURE (THEORIES)

2.4.1 Static Trade-off theory 20

2.4.2 Information Asymmetry 22

2.4.3 Pecking Order model 23

2.4.4 Agency cost theory 23

2.4.5 Other theories 23

2.5 THEORETICAL DETERMINANTS OF CAPITAL STRUCTURE CHOICE (FIRM CHARACTERISTICS)

2.5.1 Size of the firm 25

2.5.2 Asset structure 26

2.5.3 Profitability 27

2.5.4 Growth opportunities 27

2.6 CONCLUSION 28

CHAPTER 3: FINDINGS

3.1 INTRODUCTION 30

3.2 DATA AND METHODOLOGY 31

3.3 EMPIRICAL RESULTS:

3.3.1 Financial Performance findings 32

3.3.2 Relevance of financial policy regarding debt 37

3.3.3 Theory and practice of capital structure 39

3.4 CONCLUSION 42

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PAGE NO.:

CHAPTER 4: CONCLUSION AND RECOMMENDATION 4.1 SUMMARY OF FINDINGS 44

4.2 IMPLICATIONS OF EXISTING THEORY 50

4.3 RECOMMENDATIONS 51

4.4 SCOPE FOR FUTURE RESEARCH 53 BIBLIOGRAPHY

APPENDICES A-C:

Appendix A: Survey questionnaire

Appendix B: Tables I and II

Appendix C: Permission approval letter from the supervisor

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CHAPTER 1

1.1 INTRODUCTION

Research suggests that for a firm‟s survival, especially in very difficult

circumstances, capital structure is essential to measure growth and performance

(Voulgaris, Asteriou and Agiomirgianakis 2004: 247). Large companies are

exposed to increasing competition not only within South Africa but in the

Southern African Development Community (SADC), the African Union and

globally. A number of South African companies are listing internationally. For

Small, Medium and Micro Enterprises (SMMEs) survival is further complicated by

additional issues like size and reputation. For this reason the South African

government is doing its best to support the SMMEs as they are important role-

players in the country‟s economy. SMMEs maintain competition, thus keeping

the large size enterprises (LSEs) highly competitive.

Voulgaris et al. (2004: 248) are of the view that LSEs are necessary to achieve

economies of scale in production, research and marketing. The authors further

state that economic progress of countries specifically developing (transitional)

economies (like South Africa) depends on the research and development aspect.

Chen (2004:1342) agrees that not much work has been done to further

knowledge on capital structure within said economies. The abovementioned

statements have necessitated this study within the South African context.

Over the years there has been experimenting and intervention by authorities of

different countries and corporations. Market reform programmes aimed at

curbing economic decline have been introduced, intending to generate

sustainable growth and development (Boateng, 2004: 56). Four key reform

programme components, namely: liberalization of the foreign direct investment

regulatory framework; infrastructure upgrading; economic stabilization (including

fiscal deficits); privatisation, rationalization and restructuring the state-owned

5

enterprises have been suggested in Boateng (2004: 56). According to Jerome

(2004: 12-13) South Africa‟s approach to restructuring and privatisation has been

unique to other models applied worldwide. Referred to as partial privatisation by

Jerome (2004:14), the objectives include attracting foreign investment; reduction

of public borrowing requirements and assisting in the fuelling of an economic

growth. The author concedes that not much has been achieved by the

programme.

Voulgaris et al. (2004: 248) are of the opinion that LSEs tend to take advantage

by commercializing resources that have been initiated by SMMEs. There are

policies formulated to address specifically financing SMMEs for their

sustainability. When sustained, SMMEs lead in employment creation as they are

more labour intensive and more flexible than LSEs (Voulgaris et al., 2004: 248).

In South Africa ownership, procurement and mentoring based on the Broad

Based Black Economic Empowerment Act, Act 53 of 2003 (BBBEE) principles

are favourable for these small enterprises. Despite the promotion and support

by authorities, SMMEs have not managed to progress as much as the LSEs,

especially in the manufacturing sector, as Ortigvist, Masli, Rahman and

Selvarajah (2006: 278) advance the reason that SMMEs are unable to secure

adequate sources of capital. The authors refer to the argument put forth by Ang

(1991) that SMMEs are also limited in raising capital by means of shares or even

in long-term loans. The financial constraints are attributed to performance as well

as the capital structure choice of SMMEs, which according to Voulgaris et al.

(2004: 248) is, in comparison to LSEs, characterized by:

lower and more variable profitability (lower liquidity)

lower use of long-term debt

lower leverage

higher short-term debt

Debt or leverage has featured a number of times when capital structure is

debated such that both terms have been used synonymously, as witnessed in the

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characteristics presented in the Voulgaris et al. 2004 study. Both terms have

been equated to the value of the firm.

When articulating industry dynamics, Miao (2005: 2644) states that firms without

debt financing (which results in not taking advantage of tax shields and instead

financing by means of equity) have a firm value that is lower than that of firms

with debt financing.

The focus of this paper is to investigate the factors (with more emphasis on size)

that influence the capital structure of South African manufacturing firms.

Classifying firms into manufacturing and non-manufacturing will assist in

designing more appropriate and effective policies that will encourage expansion

of each type of the firm according to size, SMME or LSE (Voulgaris et al., 2004:

249).

Both the manufacturing and the non-manufacturing sectors are vital for the

growth of the South African economy, an economy in transformation. South

African firms, especially those in manufacturing, face the tough challenge of

competing for survival during critical times like the current global meltdown.

Important is that elements key to the survival of the companies in the

manufacturing industry are identified. The elements should be the basis of the

optimal capital structure.

Delcoure (2007: 400) argues that despite extensive research on what factors

determine optimal corporate capital structure, there has been no consensus on a

universal model applicable to the real business world. Existing literature on

capital structure of South African companies has so far not extensively

investigated the role of firm size and the effect of other determinants on capital

structure. Use of leverage/debt ratios to alternate industry classifications for

example manufacturing has not been sufficiently explored either. Much remains

to be understood as to whether different institutional features do influence

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leverage choices (Bancel and Mittoo, 2004: 3). These aspects have prompted

this study with a view to provide additional evidence and insights.

1.2 AIM OF THE STUDY

MAIN PROBLEM:

To investigate factors which determine the capital structure and size of firms in

order to make recommendations on policy formulation so as to improve the

financial performance of the manufacturing sector in South Africa.

SUB PROBLEMS: To recommend a model in which optimal capital structure and debt maturity are

jointly determined.

To suggest basic grounds on which detailed evaluation could be based, also

hoping to answer the following: Whether and how closely do the determinants of

capital structure support the theory that the determinants of capital structure

and/or ratios have evolved?

HYPOTHESES:

The following research hypotheses have been formulated:

size is positively related to gearing;

asset structure (acting as collateral) is positively related to gearing;

profitability is negatively related to gearing;

growth is positively related to gearing

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1.3 RESEARCH METHODOLOGY

1.3.1 Research approach and design

A research design is a set of guidelines that connect theoretical paradigm to the

inquiry strategies and empirical material collection methods to address research

problems (Mouton 1996: 107). Mouton (1996: 175) further suggests that a

research design consists of a plan on how research participants are obtained and

how information is to be collected, which Welman & Kruger (2001: 46) confirm.

This study is triangulated in that it will combine a case study which is of a

qualitative nature, as well as a quantitative type survey. The case study will

follow an interpretive approach, assuming an understanding derived from

intrusive methods on how text is interpreted. Ryan, Scapens and Theobald

(2002: 147) understand the purpose of an interpretive research to be the

development of a theoretical framework that explains the holistic quality of

observations and practices, socially. The authors are of the view that the model

is appropriate for dynamic processes in which relations between variables are

constantly changing. Structured interviews, comprising of short questions

directed to managers (mainly chief financial officers) regarding the theory and

practice of capital structure, will be conducted.

Both the case study and the survey will attempt to explain reasons for observed

accounting practices as highlighted by the financial statements.

1.3.2 Sample and data collection

The sample to be used in this study will be collected from the population of listed

companies in South Africa for the years 2003 to 2008. Manufacturing firms and

the data used are randomly selected from the Financial and Business Information

Service company data which is a database including annual reports for all South

African manufacturing companies and where the companies‟ (fiscal) financial

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information has been tracked for the recent five years. From the manufacturing

companies listed on the Johannesburg Securities Exchange between 2003 and

2008 several are excluded. Reasons for exclusion include:

unavailability of the necessary data in the consecutive periods due to non-

reporting for one or several of the years studied;

firms without complete record of all accounting items, such as long-term

debt, gross and net fixed assets, sales and operating profits are also

omitted from the dataset. These items are required for the construction of

variables;

financial sector firms because they have a different structure (in terms of

liabilities and capital structure) and might be missing a characteristic

essential in observing some of the variables;

firms with negative capital ratios.

The final sample size is the manufacturing listed companies within the Gauteng

province, the industrial hub of South Africa.

1.3.3 Methodology

The sampled companies will be stratified according to size. The size according

to which a firm is defined, either as an SMME or an LSE, can be determined

using a variety of variables for example employment, sales volume, assets or

qualitative factors such as independent ownership or management (Voulgaris et

al., 2004: 251). Employment numbers will be used as an indicator of size.

The survey will focus primarily on the determinants of the capital structure policy

of firms but will also include some questions on topics that are closely related to

the capital structure. The questions will be relevant in the South African context

regarding the financial policy. Respondents to the telephonic interviews and e-

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mailed surveys will be the managers (chief financial officers) of the sampled

companies. The same questions will be asked by the same interviewer during

the interviews. The e-mailed survey questionnaires will also comprise the

questions as in the interviews (see Appendix A). Because the questions are

standardized, every respondent responds to the same questions in the same

order (Ndlangamandla, 2005: 41). The length of the survey questionnaire is

limited to 2 pages.

1.3.4 Data

The dataset is based on financial data which is collected from the statements of

financial position (balance sheets) and statements of comprehensive income

(income statements) of the manufacturing listed LSEs and SMMEs in Gauteng.

Descriptive statistics of the data will be extracted from the tables of means and

medians of both dependent and explanatory variables, separately for SMMEs

and LSEs.

The financial data are extended to a period of 5 years so as to take into account

growth variables (for instance percentage change in sales, total assets and profit)

also including accounts such as capital stock, net worth, short- and long-term

debt, total assets, fixed and current assets, inventories, sales turnover,

depreciation, gross and net profit (Voulgaris et al. 2004: 251).

Twenty five financial ratios will be calculated based on the South African financial

framework: Generally Accepted Accounting Principles (GAAP), as proposed in

the 1978 Courtis equivalent. The selected set of ratios includes:

X1 Current assets to current debt

X2 Quick assets to current debt

X3 Net working capital to total assets

X4 Net fixed assets to total sales

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X5 Long-term debt + net worth to net fixed assets

X6 Long-term debt to total debt

X7 Total debt to total assets

X8 Net worth to long-term capital

X9 Short-term debt to total assets

X10 Inventory x 360 (days) to sales

X11 Creditors x 360 (days) to sales

X12 Accounts payable x 360 (days) to sales

X13 Sales to net fixed assets

X14 Sales to net working capital

X15 Sales to total sales

X16 Sales to net worth

X17 Net profit to gross profit

X18 Sales to number of employees

X19 Net profit to sales

X20 Gross profit to sales

X21 Net profit to net worth

X22 Net profit to total assets

X23 Percentage change in sales

X24 Percentage change in total assets

X25 Percentage change in net profits

The ratios are divided into classes which address solvency, managerial

performance, profitability and growth, assuring relative independence of each

other. The ratios completely cover a firm‟s profile. Book value will be used for

calculating variable where applicable.

Responses to questions will be used as the basis of comparison between the

different institutions‟ capital structure choice. Comparative tables according to

size, will be drawn.

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1.3.5 Measurement

The variables used in this study are adopted from the research conducted by

Voulgaris et al. (2004: 250-256), carried out on manufacturing firms.

The dependent variables, short- and long-term debt ratio are measured as the

ratio of short- and long-term debt to total assets (leverage).

Explanatory or independent variables are profitability, asset structure, size and

growth. Profitability is measured as a ratio of pre-tax income to sales turnover.

Asset structure is measured as a ratio of fixed assets to total assets. Size is

measured as the total assets in thousand rands. Growth is measured as the

percentage increase of sales turnover last four years in established firms.

Descriptive data on key variables for the five years, also taking into consideration

the different corporate factors, should indicate the financial performance of the

size groups SMMEs and LSEs. A comparison is made between SMMEs and

LSEs, in terms of liquidity, capital intensiveness, and use of short-term debt or

long-term debt for capital.

1.3.6 Analysis

According to De Vos et al. (2002: 340) the qualitative data analysis process is a

search for general statements about relationships among categories of data,

building grounded theory. The process involves an inseparable relationship

between data collection and data analysis. The data will be analysed on the

basis of financial performance of the two size groups and in terms of:

solvency/liquidity is looked at on short- and long- term basis, with

ratios X1 to X3 covering the short-term and X5 being a long-term

ratio

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managerial performance is assessed in terms of:

o asset structure (ratios X4, X6, X7; X8 and X9);

o inventory (ratio X10)

o credit policy (ratios X11 and X12)

o administration (ratio X18)

profitability is classified into:

o capital turnover (ratios X13, X14, X15 and X16)

o profit margin (ratios X17, X19 and X20)

o return on investment (ratios X21 and X22)

growth (in established firms) is denoted by ratios X23, X24 and

X25

(Source: Voulgaris et al. 2004: 252)

The importance of each factor (in the questions), will be ranked according to

importance on a scale of 0 to 4 and a mean rank will be determined. The highest

mean rank will represent the most important factor.

1.4 RESEARCH STRUCTURE

1.4.1 Chapter 1: Introduction and Research design

Chapter 1 introduces the topic, encompassing the purpose, the objectives and

motivation of the study. The aspects of research design are provided, entailing

the methodology, sampling and data collection and analysing procedures.

Definitions of key concepts are also expanded on.

The research design includes the research methodology followed in obtaining,

processing and analysing data. A sample of the structured questions applicable

is included. The design also outlines and discusses practical applications,

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challenges encountered and delimitations of the study. Ethical considerations

are also advanced.

1.4.2 Chapter 2: Literature review

The theoretical background provides information and models which have been

the basis of previous research. To contextualize the theory and models, more

literature has to be reviewed, especially the most recent views.

1.4.3 Chapter 3: Findings

This chapter includes an outline of detailed discussions on the research findings.

An analysis and interpretation of data from the ratio calculations is presented.

The researcher will also try to collate the responses from the questionnaire with

the financial data. Comparisons between the literature review and the findings

from the study will be conducted, without bias.

1.4.4 Chapter 4: Recommendations and Conclusions

Closing comments which entail a report and discussion on the summary of

findings are made. Recommendations and conclusions are put forward. This is

then followed by the list of sources used in informing the study and the

subsequent appendices if any.

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CHAPTER 2 2.1 INTRODUCTION

There are three main theoretical areas that inform the present study, namely

capital structure as against the firm value, capital structure theories and firm

characteristics. Firstly, the study attempts to establish whether a link exists

between capital structure and firm value. Contention and analysis by various

researchers is referred to in this regard. Secondly, the study refers to the

theoretical models proposed in a number of studies, making them the basis of

this paper. To understand the different interpretations of capital structure choice,

it is important to reflect on the theories. This chapter also discusses firm

characteristics previously identified as being influential in determining an optimal

capital structure. The significance of the influence is measured against the

results which are supported by evidence. Several key theoretical concepts used

throughout the paper have been explained.

2.2 CAPITAL STRUCTURE VS FIRM VALUE

While carrying out capital structure research, corporate finance researchers have

suggested that a link exists between a firm‟s value and capital structure, such

that one cannot isolate the terms from each other. Voulgaris, Asteriou and

Agiomirgianakis (2004: 249) believe capital structure to be a crucial aspect in a

firm‟s performance, a statement that has occupied financial researchers. De Wet

(2006: 1) views this statement as a focal point that financial managers (and

researchers alike) still grapple with in their endeavour to maximize shareholders‟

wealth. Hatfield, Cheng and Davidson (1994: 1) entered the fray, referring to the

considerable debate on whether there is an optimal capital structure for an

individual firm. Whilst articulating on optimal capital structure, the authors

brought up another dynamic, questioning whether debt usage is irrelevant to the

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individual firm‟s value. In linking optimal capital structure, debt usage and firm

value Eriotis, Vasiliou and Ventoura-Neokosmidi (2007: 322) start by justifying

that employment of debt is crucial in achieving the optimal capital structure. The

authors explain this by showing how tax benefits (tax shields contributing to firm

value) should be balanced with the costs of debt financing (as part of a capital

structure). De Wet (2006: 2) strongly believes that the impact of the capital

structure on the value of the business is of paramount importance.

However, other researchers have a different view point on the impact of capital

structure on the value of the firm. Frielinghaus, Moster and Firer (2005: 9) argue

that the research on why capital structure matters and how it contributes to the

overall value of the firm, has proven inconclusive, hence the vigorous, ongoing

debate. In Kyereboah-Coleman (2007: 271) the Modigliani and Miller (1958)

study is analysed based on the contention that capital structure is irrelevant to

firm value as capital structure does not affect a firm‟s cash flow. Cheng and Shiu

(2007: 30) also interpret this contention as suggesting that firm value is

independent of firm capital structure. Both studies term the Modigliani and

Miller‟s basis as restrictive and unrealistic. Kyereboah-Coleman then proposes

that the assumptions be adapted to more realistic expectations which will prove

that capital structure decisions do, in fact, affect a firm‟s value.

According to De Wet (2006: 1-2), what baffles financial managers in determining

an optimal capital structure, is the question whether it is the sources of capital

used that affect the value of a company and to what extent . The author lists

some of the factors that influence the way in which a company raises finance,

including the:

existing level of operating leverage (fixed costs relative to variable costs);

cost of the particular source of capital used;

impact of this form of financing on the control of the company;

risk attached to the source of finance and

various tax implications and financial distress costs.

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De Wet concedes that the factors do play some role but the emphasis should be

on the target capital structure which impacts on the value of a business. Defining

the target (optimal) capital structure, he refers to the combination of equity and

debt that will maximize the value of the firm, with all things being equal.

Researchers have also tried to extend the influence of capital structure beyond

the firm value. In addressing concerns of an optimal capital structure existence

for an individual firm as well as irrelevance of the proportion of debt usage to

individual firm value, Hatfield et al. (1994: 2) scrutinize the relationship between

the industry and capital structure. The authors conclude that the industry to

which a firm belongs, may be influential to that firm‟s capital structure. Delcoure

(2006:400) examines capital structure choices in different foreign markets, finding

some similarities and differences – suggesting further interrogation in this regard.

Chui, Lloyd and Kwok (2002: 100-101) complement previous studies by Grinblatt

and Keloharju (2000), Stonehill and Stitzel (1969) and Sekely and Collins (1988)

which examine specific cultural dimensions on capital structure.

2.3 KEY THEORETICAL CONCEPTS

The following are the concepts used in this study.

2.3.1 CAPITAL STRUCTURE

In Kyereboah-Coleman (2007: 271) capital structure is defined as the relative

amount of debt and equity used in financing the operations of a firm.

Boateng (2004: 57) provides a definition of the capital structure as a ratio of total

debt to total assets at book value. In dispelling the Modigliani and Miller theory,

Boateng (2004: 58) concludes by pointing how much the capital structure matters

in reality, especially in cases where banks have to finance projects with debt

capital.

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Correia, Flynn, Uliana and Wormald (2006: 535) refer to optimal capital structure

as, debt-equity ratio that is applied by a company to have the lowest Weighted

Average Cost of Capital (WACC).

Lambrechts (1990: 510) simplifies capital structure by referring to as the liability

side of the balance sheet, made up of the shareholders‟ interest and the

borrowed capital of a firm. Interestingly the same authors use the term Financing

Structure interchangeably to capital structure, suggesting the composition of

forms of financing in terms of the required ratio between debt and shareholders‟

interest. The author advances aspects to be considered when financing policy

guidelines are formulated, including:

differentiation between shareholder capital and debt as financing forms;

differentiation between fixed and current assets as well as permanent and

variable capital requirements;

limitations of the discussion on the management of manufacturing industry

as public companies;

profitability, liquidity, solvency and control.

2.3.2 WEIGHTED AVERAGE COST OF CAPITAL (WACC)

The Weighted Average Cost of Capital is the common way in which the cost of

capital is expressed and has two main components: debt and equity and their

relative weightings. Where tax calculations are applicable, they should be

affected.

WACC assumes that when an entity raises finance, the cash raised is added into

the pool of funds. When a potential investment project is identified, the project is

assumed to be financed from the pool (a mix of equity, debt and preference

shares). Should this mix remain constant over time, the discount rate applicable

would be the cost of the pool funds, that is, the WACC. The WACC can be

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derived by calculating the cost of each long-term source of finance weighted by

the proportions of finance used (CIMA: Financial Strategy: 2006: 157-159).

In Vigario (2006: 68-70) as well as in www.costofcapital.net, there are other

factors that are suggested regarding WACC:

Use of market values of the various components when weights are

determined and in the absence of market values (or where specifically

requested), book values should be used. Vigario (2006) notes that that

WACC calculated at book value has little value.

There are instances where a target structure (that is, the sequence and

the proportion in which the structure is proposed by each company) is

suggested, it is recommended that such target structure be fulfilled.

When the WACC is used as a discount rate in incremental projects, the

assumption is that the new project has the same risk profile than existing

projects.

WACC can be used as a cut-off or discount rate for calculating the net

present values (NPVs) of projected cash flows for new investments

provided:

the capital structure is reasonably constant.

if the capital structure changes, the WACC calculation will change

as this will alter the required return characteristics due to the

change in risk.

the new investment is marginal (relatively small in relation to the

total capital structure) to the entity.

Lower WACC means higher value whereas a higher WACC is equal to

lower value.

WACC is expressed as a percentage.

WACC technique may be the most relevant approach for gearing

purposes.

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Correia and Cramer (2008: 46) concluded that the determination of a company‟s

weighted average cost of capital requires a firm to determine a relevant capital

structure. The weighted average cost of capital represents a composite rate of

return that can be used to undertake firm valuations (Correia and Cramer, 2008:

34).

2.3.3 LEVERAGE (DEBT) RATIO

Voulgaris et al. (2004: 249) define leverage as the amount of foreign capital

(liabilities) reflected on a company‟s balance sheet, which is expected to grow as

the company size grows, particularly if the lender is no security risk (that is it can

be able to pay the debt).

Correia et al. (2006:534) maintain that leverage/gearing is the relative use of debt

in the capital structure, intended to increase the return on shareholders‟ funds in

exchange of greater financial risk.

2.4 LITERATURE ON CAPITAL STRUCTURE (THEORIES)

Reference has repeatedly been made to prior theories, with the 1958 Modigliani

and Miller model being the pioneer. Pagano (2005: 237-246) reviewed most

theorems on the basis of the Modigliani and Miller model and their relevance to-

date. Of interest from the reviews is what informs the arguments of this research.

2.4.1 Static Trade-off Theory

The Modigliani and Miller model started by debating that the market value of any

firm is independent of its capital structure, based on the premise that capital

structure does not affect a firm‟s cash flow (Kyereboah-Coleman, 2007:271).

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When interpreted, the argument shows that the capital structure is not expected

to vary from company to company. Barclay & Smith (2005: 8-9), following on

their preceding 1995 and 1999 papers, justify this „invariance‟ argument by trying

to understand the conditions under which it was developed. The authors

conclude that the conditions could be deliberately artificial and could be excluding

information costs, personal or corporate taxes, contracting or transaction costs,

and a fixed investment policy.

In 1963 Modigliani and Miller revised their initial stance that the financing

decisions of firms do not affect their value, suggesting that firms with higher

profits should use more debt, thus substituting debt for equity to take advantage

of interest induced tax shields. Kyereboah-Coleman (2007: 271) sources Myers

(1984) as advancing the static trade-off theory. The theory explains how a firm

decides on the debt-to-equity ratio – on the assumption that some optimal capital

structure exists, enabling the firm to operate efficiently and ensuring external

claims on cash flow are reduced. Miller (1988: 100) contends this to imply that

firms are encouraged to increase their debt levels. For this reason, Voulgaris et

al. (2004: 249) argue that a trade-off between tax gains and increased

bankruptcy costs increases a firm‟s cost of capital. In highlighting limitations to

optimal level of firm debt, Voulgaris et al. consider the arguments of the Stiglitz

1974 and 1988 papers; that bankruptcy costs increase as the firm‟s level of debt

increases. Myers & Majluf (1984: 219-220) proposed that firms should attempt to

achieve an optimal capital structure that maximizes the value of the firm by

balancing the tax benefits with bankruptcy costs which are associated with

increasing levels of debt.

Since the evolution of the trade-off theory, debate has raged with researchers

adapting the assumptions to more realistic expectations and analysis

(Kyereboah-Coleman, 2007: 271). One amongst some identified shortcomings,

is that in reality high profitable companies tend to have less debt than less

profitable companies as the former utilize the profits for financing.

22

Warner (1977: 345) pointed that bankruptcy costs are much lower than the tax

advantages of debt, implying much higher debt than predicted. The Pinegar &

Wilbritch (1989) study is quoted in Ortqvist et al., (2006: 279), as encouraging the

use of debt with minimum costs increases the amount of resources available for

growth and expansion.

2.4.2 Information Asymmetry

In 1977 Ross developed the Information Asymmetry theory which sought to

remove another underlying assumption from the Modigliani and Miller‟s 1958

model „value invariance theory‟. The theory suggests that full information about

activities of firms can be known to external stakeholders. Information in

managers‟ possession regarding firm‟s future prospects (which the market does

not have) might be exposed by the capital structure choice of these managers.

The market is given an indication by some pointers within the financing structure.

The reasoning behind that would be that when leverage is increased, the value of

the firm would subsequently be increased, thus signalling the size and stability of

future investments. However, Fama and French (2002: 7), with reference to the

Myers (1984) study, contradict the Ross argument. The authors believe that

increasing debt actually signals poor prospects for future earnings and cash flow,

as there will be less internal financing available to fund development. Voulgaris

et al. (2004: 249) noted the view from a Binks and Ennew 1996 study, that

information asymmetry implies there is a positive relationship between debt and

asset structure in terms of high fixed asset ratio. In simple terms, the higher the

value of assets, the higher the loan amount extended. Voulgaris et al. (2004:

249) in defining leverage, further affirms the prospects of the liability growing with

size. Ross points out that firms use more debt to overcome information

asymmetry.

23

Myers & Majluf (1984: 209) observed the sequence in which firms finance

tangible assets growth - relying on internally generated funds first, followed by

debt and external equity issue, respectively. Reasons advanced by Voulgaris et

al. (2004: 249) are that internal funds are considered to be cheap and there is no

outside interference from the funder. Chen (2004: 1342) points out that in such a

case there is no need to issue security in terms of fixed assets.

2.4.3 The Pecking Order model

Contrasting the static trade-off theory, Myers & Majluf (1984: 194-195) discuss

the rational of the Pecking Order model (POT) of corporate leverage, which was

later supported by amongst others Chen (2004: 1342). The model is explained

by what has been observed in companies, which is the tendency of not issuing

stock (shares) and instead, holding large cash reserves. Myers & Majluf

conclude that this is unnecessarily holding financial slack as a consequence of

possible conflict of interest by managers as well as between old and new

shareholders. Chen‟s (2004: 1342) view is that only when forced by

circumstances do companies resort to external financing, using debt before

equity. To highlight the contrast Kyereboah-Coleman (2007: 271) explains the

pecking order theory to be suggesting that the profitability of a firm does influence

its financing decisions. The study elaborates the contention that firms which

have not predetermined their debt and equity mix, prefer internal to external

financing. An observation is that the pecking order framework tends to overlap

the asymmetric information and the agency cost theories.

2.4.4 Agency cost theory

Kyereboah-Coleman (2007: 271) interrogates the identification of an optimal

capital structure and its explanatory variables. The author starts by asking what

motivates the selection of a debt and equity mix. As a result, the agency cost

theory is proposed and explained as when managers have the information

24

regarding the prospects of the company, use that information for their own

interests which are different from those of shareholders. Subsequently, firms use

more debt in their capital structure especially when management is pressurized

by the shareholders to use funds efficiently so as to be able to pay out future

cash flows (for example dividends) (Kyereboah-Coleman, 2007:271). Barclay

and Smith (2005: 11) refer to this theory as signalling – signalling a firm‟s

(in)ability to meet its obligations. Barclay and Smith (2005: 11) confirm the notion

by Jensen (1986) that agency costs give enough reason for firms to increase the

amount of debt in their capital structure. The authors suggest increasing debt as

a credible signalling mechanism. Other than that, agency costs become higher

when the organization generates substantial free cash flow (surplus cash after

expenses including investments have been paid). There is a further assumption

that debt is less effective in rapidly growing organizations.

2.4.5 Other theories In addition to the previously cited theories/models, Voulgaris et al. (2004: 249)

also refer to the theory of finance on capital structure and the debt structure.

The paper outlines the process of testing of the theory of finance on capital

structure, empirically and separately on the different types of firms (which are

manufacturing and non-manufacturing firms in this instance). The process entails

the development of models containing factors that are expected to influence the

debt ratio of the different firms. After comparing the results, policy measures are

accordingly formulated. A firm debt structure is characterized by size,

profitability, asset structure, collateral, liquidity, age, access to capital markets,

risk and growth.

Chen (2004: 1342) summarized the effect of capital structure theories with the

empirical evidences on the relationship of capital structure determinants with

leverage has also been confirmed by the results of this study.

25

2.5 THEORETICAL DETERMINANTS OF CAPITAL STRUCTURE CHOICE (FIRM CHARACTERISTICS)

Based on theories of capital structure and previous empirical literature, a variety

of variables have been identified as potentially responsible for determining capital

structure decisions in companies.

Cheng and Shiu (2007: 34) chose five characteristics that might be correlated

with leverage which included growth opportunities, firm size, profitability, asset

structure and business risks. Mazur (2007: 499) listed ten factors, adding

liquidity, product uniqueness, non-debt tax shields, dividend policy and effective

tax rate to Cheng and Shiu‟s factors.

This study is hypothesized around the following four variables:

2.5.1 Size of the firm

Size is considered a variable that determines the differences in leverage among

firms (Eriotis, Vasiliou and Ventoura-Neokosmidi, 2007: 325). A number of

researchers agree that larger firms tend to be more diversified and as a result

they are less likely to become bankrupt. Kyereboah-Coleman‟s (2007: 274) input

is that these firms are able to absorb risk, have lower probability of default, tend

to have easy access to credit and have more diluted ownership. The more

diversified, the lower the variance of earnings, enabling the firms to use more

debt, tolerating high debt ratios as Abor and Biekpe (2005: 39) put it. Mazur

(2007: 501) supports the notion of easier access to the market adding that the

firms can also borrow at better conditions, thus reducing transaction costs and

tax rates. According to Eriotis et al. (2007: 325) large firms will more easily

attract a debt analyst to provide information to the public about debt issue.

Cheng and Shiu (2007: 35) link the size characteristic to some of the theoretical

models. The authors point out that the diversification of large firms and the

26

subsequent lower financial distress costs are resultant of the static trade-off

model. This model predicts a positive relation between firm size and leverage.

The size of the firm is also used mainly in finance literature, representing

valuable information to potential investors, creditors and credit markets (Cheng

and Shiu, 2007: 35). The extent of the asymmetric information can have an

impact on the association between size and leverage, as previous research

suggests.

2.5.2 Asset structure

An asset structure is often suggested as an explanatory determinant as it

includes fixed assets which can serve as collateral (Mazur: 2007: 499).

Kyereboah-Coleman (2007: 274) concurs with Mazur in that the security feature

(in terms of debt) is consistent with the trade-off theory. A suggestion is that

more of the assets should be tangible so as to derive greater liquidation value

when accessing finance (Abor and Biekpe, 2005: 40). The authors warn though

that this could lead to higher debt or outside financing in the capital structure.

Tangibility is measured as a ratio of fixed assets to total assets (Cheng and Shiu,

2007: 35). The Abor and Biekpe study confirms other papers‟ conclusion that a

significant positive relationship exists between asset tangibility and firm debt

specifically in large firms.

However, a negative relationship is identified as coming through the pecking

order theory, also a prediction that firms holding more tangible assets will be less

prone to asymmetric information problems. This means such firms are less likely

to issue debt (Mazur, 2007: 499).

27

2.5.3 Profitability

The existence of a relationship between firm profitability and capital structure can

be explained in terms of the pecking order theory (Abor and Biekpe, 2005: 40).

The theory assumes that because of information asymmetry between insiders

and outsiders firms prefer to finance using internal funds rather than external

finance (Cheng and Shiu, 2007: 35). Availability of internal funds depends on

profitability as well as liquidity (Mazur, 2007: 500). According to Mazur profitable

firms are more likely to generate internal funds and it is expected that firm

leverage would decrease due to profitability – affirming the pecking order

hypothesis of a negative correlation between profitability and capital structure.

Linking profitability to the static trade-off theory, Cheng and Shui (2007: 35)

advance the theory contention that more profitable firms will use more debt as

these firms have better ability to take on debt. High debt levels attract tax

shields, implying a positive relationship between profitability and debt (Mazur,

2007: 500).

Kyereboah-Coleman (2007: 274) bases the inverse relationship between capital

structure and profitability on the theory of agency cost which compels managers

to be disciplined when considering debt. The importance of shareholders‟ wealth

is emphasized.

2.5.4 Growth opportunities

In Ortqvist, Masli, Rahman and Selvarajah (2006: 282) growth is expressed as a

proxy of risk, implying that the higher the growth, the higher the risk. The paper

also points to other arguments that growth does not necessarily generate income

that needs to be covered by debt - meaning that growing ventures have lower

debt ratios. Accordingly, research findings expose a negative relation between

growth and capital structure. However, other authors have proposed a different

28

view, prompting another group to suggest that the relation will differ depending

on whether the focus is on short-term or long-term debt ratio. Hall, Hutchinson

and Michaelas (2000) (quoted in the Ortgvist et al. paper) hypothesise that long-

term debt ratio would be negatively related to growth regards to SMMEs, while

short-term debt ratio would be positively related to growth within the same

context.

Mazur (2007: 501) refers to a common argument that growing firms have more

opportunities to invest in risky projects at the expense of creditors, resulting in an

inverse association between leverage and growth opportunities.

Due to inconclusive findings, Abor and Biekpe (2005: 41) base their input on the

pecking order hypothesis, suggesting that growing firms place a greater demand

on the internally generated funds of the firm thus capturing higher debt ratios.

The authors also highlight the existence of a relation between the degree of

previous growth and future growth. Future opportunities are predicted to

positively relate to leverage. Cheng and Shiu (2007: 34) caution highly levered

firms as they are more likely to pass up good investment opportunities compared

to their counterparts with less debt.

According to Eriotis et al. (2007: 325) growth is measured in terms of the change

in annual earnings whilst Mazur (2007: 501) advance average growth rate of total

assets, average growth rate of revenues from sales and long-term investment to

total assets as proxies of growth opportunities.

2.6 CONCLUSION

This chapter has introduced the linkage of capital structure to shareholders value

which is on its own vital. Capital Structure models have also been engaged as

the basis of analysing the four envisaged determinants of the capital structure.

29

This study predominantly draws on the latter approach. The study also shows

the importance of leverage (debt) or the debt/equity ratio as a concept that is

synonymous to element(s) of capital structure and its role within the analysis of

the structure.

The next chapter entails the computation and interpretation of the ratios, the

analysis of the responses to the questions on the survey questionnaire, their

linkage to the determinants as well as the findings in relation to the existence of

relationship(s) between determinants and the theories.

30

CHAPTER 3

3.1 INTRODUCTION

This chapter aims to answer the question: „Whether and how closely do

determinants of capital structure support the theory that the determinants of

capital structure and/or ratios have evolved?‟ The chapter also attempts to

explain reasons for the observed accounting practices, specifically in terms of the

Generally Accepted Accounting Practices (GAAP) and the International

Accounting Standards, which are highlighted in financial statements (Ryan et al.,

2002: 144).

The chapter presents an analysis of the determined twenty five (25) ratios in

relation to the dependent variables (short- and long-term debt ratio), addressing

solvency or liquidity of the different size enterprises (SMMEs and LSEs) and

explanatory or independent variables (profitability, asset structure, size and

growth). The latter variables seek to address managerial performance,

profitability and growth within the groupings. Published financial statements of

five SMME and five LSE firms were obtained electronically. The sampled ten

companies (confirming the same characteristics), five SMMEs and five LSEs,

were provided the survey questionnaire.

The structured questionnaire was e-mailed to the ten enterprises and an

additional one to a subsidiary of one of the LSEs. Telephonic interviews were

also conducted as means of following up and soliciting responses on the

questions (from those companies who had not replied to the e-mail) based on

debt policy applied by the different enterprises. A comparative analysis of the

responses is presented in Appendix B: Table II: Survey Report. The report

includes a percentage of the „important‟ response as well as means of responses

to the questions, separately for SMMEs and LSEs.

31

3.2 DATA AND METHODOLOGY

Challenges experienced by Bancel and Mittoo (2004:25), in the survey data and

methodology include (i) response validity that is, whether the respondents have

truthfully answered the questions asked in the survey and (ii) non-response bias

that is whether the respondents are representative of the population studied,

were also of concern to the researcher.

On examining the extent the responses reflect the reality in the field, the author

ended up being comfortable with highlighting the importance of financial flexibility

and the reasonability of the responses as suggested by Bancel & Mittoo

(2004:25). The author also noted the timing of the survey, conducted during

recession, a period of uncertainty and low market liquidity which could influence

responses to financial flexibility. The author also expected the data (extracted

from the financial statements including responses from the management of these

enterprises) would relatively vary as a result of the economic down turn during

year 2008. Acknowledgements of the envisaged effects of the recession have

been made in the analysis throughout the study.

The proportions of the respondents across manufacturing listed companies within

the Gauteng province met the criteria of the initial sample. All the sampled

companies are in the manufacturing industry with a fair spread in diversified

operations and mining. By the nature of the sampled firms‟ characteristics, the

author is confident that the firms are representative of the manufacturing

enterprises across Gauteng.

From the data in the financial statements, twenty five ratios were computed,

enabling the determination of means and medians for both the dependent and

explanatory variables for SMMEs and for LSEs. The statistics show the average

indicators of variables computed from the financial statements (Abor & Biekpe,

2005: 43). Different classes, including solvency, managerial performance,

profitability and growth, with relative independence of each other assured, are

32

reflected (see Appendix B: Table I: Summary statistics of dependent and

independent variables and Tables A1 to A4 for SMMEs and LSEs tables of

means and medians) (Voulgaris et al., 2004: 251).

Six out of the eleven company managers (approximately 55%) were able to

provide precise responses to all the questions in the questionnaire. The

respondent firms represent 50% (two out of four) of the surveyed SMMEs and

60% (four out of six) of the surveyed LSEs. 80% (four out of five) of the LSEs on

which a case study had been conducted, responded.

3.3 EMPIRICAL RESULTS

3.3.1 FINANCIAL PERFOMANCE FINDINGS

An analysis of the financial performance of the two size groupings shows how

South African SMMEs fare compared to LSEs in terms of liquidity, capital

intensiveness, use of short- or long-term debt, reliance on inventory and

suppliers‟ credit as well as profitability. The analysis asserts the fact that SMMEs

are characterized by lower and more variable profitability (lower liquidity), lower

use of long-term debt, lower leverage and higher short-term debt (Voulgaris

2004: 248). The observation is made on the basis of Tables I and II. Growth and

size of the enterprises also feature in the analysis.

Short-term solvency and liquidity

Solvency/liquidity ratios represent the extent to which an entity can pay its short-

and long-term (by way of interest payments) financial obligations which is

measured by the liquidity ratios (Berry, De Klerk, Doussy, Du Plooy, Jansen van

Rensburg, Ngcobo, Rehwinkel, Sceepers, Swanevelder & Viljoen: 2007: 345).

33

In addressing the dependent variables: short-term, long-term debt and total debt,

the liquidity ratios below were computed.

Current assets to current liabilities, denoting the current ratio, resulted in the

mean of SMMEs at 1:1, concluding that, in the short-term, SMMEs are in a

position to settle their debts within the limits of a cash cycle (flow of cash in and

out of the business as a result of normal trading operations) (CIMA 2008:360).

The inventory holding period (inventory/cost of sales x 360 days), another

element of the cash cycle, averages 77 days for SMMEs which could if regarded

as excessive, is a negative attribute. In compensating for the length of holding

inventory, accounts payable/creditors are delayed by a shorter 54-day period. In

comparison LSEs current ratio mean of 2:1 indicates more than adequate liquid

assets to cover short-term debt and in turn compensates the longer inventory

turnover period of 83 days. Accounts payable are delayed by 84 days by the

LSEs. Investing in working capital is another element considered in the cash

cycle and SMMEs had invested 21.7% LSEs 15.7%. The higher average

investment in capital for SMMEs concurs with the argument that SMMEs tend to

rely on more capital than debt due to the lack of collateral and subsequently

restrained to access credit (Voulgaris et al. 2004: 250). At the same time LSEs

payment period (credit policy) is extended due to their ability in securing debt

based on their liquidity and extended asset structure.

Quick assets to current debt:

CIMA (2008: 361) recommends a quick/acid test ratio of 0,8 which has not been

matched by either entity, with means of 1:2 for SMMEs and 1:1 for LSEs

respectively. The SMMEs situation is not comfortable as, with the exclusion of

inventory, current assets are less than the current liabilities, an indication of not

being able to cover short-term debt. The SMMEs longer period of inventory

turnover could also be a negative factor. The mean of the LSEs also indicates an

impact of the high built-up inventory levels. Without a receivables collection

period, no definite deduction can be made on the liquidity of the firms.

34

Net working capital (current assets less current liabilities) to total assets:

The means of 1:5 and 1:45 for SMMEs and LSEs respectively indicates that the

remainder of working capital is approximately 20% of total assets for both smaller

and larger entities. For SMMEs the working capital means long-term funds

which consist mainly of a firm‟s own funds (profit and capital) (Voulgaris et al.

(2004: 256). In both size firms, the deduction is that the organizations are

revolving the same debt. The large total asset portion of the LSEs can also be

attributed to extensive use long-term debt in acquiring the assets.

Long-term debt plus net worth to net fixed asset is concerned with how much the

company owes in relation to its size (CIMA, 2008: 356.) The ratio is a measure

of long-term debt (payable) from non-current assets. The exclusion of current

liabilities from equity highlights indebtedness which, when out of control results in

liquidation (CIMA 2008: 357) or non-qualification in accordance with the National

Credit Act in the South African context. The mean of SMMEs is 2:1 and for LSEs

is 1:1. The LSEs ratio falls within the acceptable limit according to CIMA

(2008:357).

Independent/explanatory variables are addressed by looking into the classes of

profitability, managerial performance and growth.

According to Berry et al. (2007: 342), profitability ratios measure a firm‟s profit

for a specific period relative to sales, assets or equity for that period. The ratios

include:

Capital turnover is measured in terms of sales as a percentage of either net fixed

assets or net working capital or total assets or net worth (equity), to assess

whether capital has been invested appropriately in terms of generating enough

sales. The averages for SMMEs are (in the respective sequence) 271%, 417%,

117% and 191% and for LSEs 202%, 288%, 107% and 255%, respectively. For

both groups there is an actual increase or constant investment in assets between

2004 and 2006 declining in 2007. The scenario changes from 2008, highlighting

35

possible revenue change. The fluctuation can be attributed to the global

downturn. The mean percentages for SMMEs are significantly higher than those

of the LSEs in all but one aspect which is net worth. The same deduction of

more use of long-term debt (which inflate total assets) by LSEs compared to

SMMEs and concentration in investing in capital by SMMEs, can be made.

Return on investment (ROI) indicates the rate of return earned on funds invested

in an entity by the owners (Berry et al., 2007: 343). The ratio calculates net profit

as percentage of the net worth (which is equity excluding borrowings). For

SMMEs, the exclusion of borrowings bears a higher mean of 22%. In

comparison, the average return on total assets ratio (ROA) is 10% for SMMEs.

The inclusion of borrowings prompts the suggestion that SMMEs rely mainly on

capital employed rather than debt, with a possible consequence of limited access

to borrowed funds. For LSEs the mean for ROI is 16% whereas for ROA is 8%.

Under-valuation of non-current assets resulting in unrealistically low capital

employed can be attributed to a low ROA (CIMA 2008: 353).

Profit margin ratios express net profit (for the period) as a R1 of sales (Berry et

al. 2007: 344). The authors contend that these ratios indicate management‟s

ability to operate an entity with sufficient success in recovering the cost of

inventories, operating expenses, interest obligations as well as owners‟ interests.

For both groupings the ratios show more or constant expenditure patterns until

2007, with a significant turn-around for LSEs in 2008. The average ratios are

10% for SMMEs and 8% for LSEs. The low ratio implies low sales prices and

high expenditure in cost of sales and period costs resulting in depressed sales

revenue (CIMA, 2008: 355). The other ratios are gross profit to sales and net

profit to gross profit which yield means of 16% and 39% for SMMEs and 20% and

41% for LSEs. CIMA (2008: 355) highlights a trade-off between profit margin

and asset turnover (a measure of how well the assets are being used to generate

sales). The trade-off expresses the notion that profit margins tend to be higher

when the asset turnover is lower, whilst a fall in profit margins is compensated by

a higher asset turnover.

36

Managerial performance is assessed on the asset structure and the

management of inventory, the credit policy and administration. Solvency; short-

and long-term is also part of the assessment but has been addressed as a

criterion on its own. Inventory turnover and the credit policy have also been

referred to under solvency, above.

The asset structure ratios include the ratio: long-term debt to total debt which

yields a mean is 1:3 for both SMMEs and LSEs. The ratio indicates that the

equity of the entities have generated enough profits to cover interest obligations

on the debt (Berry et al. 2008: 349). Capital as a portion of equity is measured

by comparing net worth to long-term capital and is 1097:1 for SMMEs, reflecting

capital intensiveness of SMMEs in comparison to LSEs which have a mean of

104:1 (Voulgaris et al. 2004: 250). For each grouping one firm had very high

proportions of net worth which could be as a consequence of changes (possible

increase) in retained earnings or an increase due to revaluations. Short-term

debt to total assets yields respective means of 1:3 and 1:6 each grouping,

showing how much the short-term debt is covered by the assets, this in securing

collateral. SMMEs have proven to own less assets to secure debt than LSEs,

affirming the theories on collateral. Management of administration reflects the

contribution of each employee of the entity towards sales revenue. In SMMEs

each employee contributed an average of R434 952 whilst an employee‟s

contribution in LSEs averages R715. The differences are due to the difference in

numbers of employees in the different sized establishments, with more

employees in LSEs than in SMMEs.

Growth is measured as the percentage change (increase) in sales, a change

which could be as a result of a change in the quantity supply or in the price. The

average (mean) change between years 2004 and 2007 is equal to 26% for

SMMEs and 20% for LSEs. Generally, an average increase of 20% and more in

sales (revenue) equates positive growth. A change in total assets is attributed to

either acquisitions of assets or a change in retained earnings. SMMEs have a

37

mean of 35% (with a significant increase of 57% in 2007) whilst LSEs have a

mean of 19%. An increase in retained earnings rather than asset acquisition

could be attributed to the higher SMME average percentage whereas the inverse

could be applicable to LSEs. A change in net profit implies a change in revenue

in relation to assets. The means for SMMEs and LSEs are 43% and 54%

respectively. The traded-off theory suggested by CIMA (2008: 355), of a higher

profit margin and a lower asset turnover, has an influence in the reasoning for the

change.

3.3.2 RELEVANCE OF FINANCIAL POLICY REGARDING DEBT

Responses of chief financial officers and or managers who were asked about

their opinion on various factors that are likely to influence capital structure

policies, are examined and aligned to factors interrogated in the survey

questionnaire (Bancel & Mittoo, 2004: 8). Two sets of factors are selected based

on (i) the implications of theory and practice of the capital structure and (ii) debt

policy. Both sets relate to financial flexibility in as far as how debt and or equity

issues impact on the capital structure changes.

The summary of responses, as tabled in Table II, and subsequent implications

thereto are discussed below.

On the theory and practice of the capital structure, maintaining a target debt-to

equity ratio was regarded as the most important at 100%, a mean of 1 for

SMMEs and a mean of 2 for LSEs. Use of long-term debt for LSEs could be

influential on the decision. On fund activities, the respondents concurred that is

it is very important to consider whether recent profits are sufficient, at 100% with

an SMME mean rank of 1 and 1.67 for LSEs. Fairing close behind is the

managers‟ timing of debt or equity issues as a very important factor likely to

influence a firm‟s capital structure policies. 67% of the managers regard the

factor important with a 1 mean ranking for both small and large organization. The

38

extent to which different stakeholders influence the firm‟s financial decisions and

other factors including capital structure theories and capital structure changes on

financial statements, is regarded less important, all scoring 33% on importance

with mean ranks of 1 for both SMMEs and LSEs. The inability to obtain funds

using other sources is considered least important by 17% of the managers

(mean rank 1 for both groups). No manager puts any importance on stock being

the least risky source of funds (mean 1 for SMMEs and 1.25 for LSEs).

On the debt policy, the factors that affect how the appropriate amount of debt is

chosen and the tax advantage of interest deductibility are the most important at

100% and mean ranks of 2 and 4 for SMMEs and LSEs respectively. Tax

advantage of debt and the timing of debt/equity issue are also of importance to

the firms with 100% of the managers confirming this, yielding means of 1 for the

different size groupings on both factors. Matching the maturity of debt with the

life of assets is 67% important in choosing between short- and long-term debt

(mean: SMME = 1 and LSE = 2). The question of issuing short-term while

waiting for long-term market interest rates to decline, was also responded to by

67% of managers (mean: 2 for SMMEs and 4 for LSEs). Ensuring that upper

management works hard and efficiently is considered by another 67% in the

choice of appropriate amount of debt (1 and 1.33 mean for small and large firms

respectively). Only 50% respondents consider the choice between short- and

long-term debt and the potential costs of bankruptcy as important with means of

between 1 and 1.33. 33% of managers rate issuing of debt when the firm has

accumulated profits as important (1 is the average for both groupings).

Borrowing short-term to reduce the chance of taking on risky projects and issuing

long-term debt to minimize the risk of financial “bad times” are both ranked

important by 17% mangers (mean: 1 for SMMEs and 1.67 for LSEs). No

respondent considers the issuing of debt when recent profits are not sufficient for

funding activities as a factor of debt policy (1 SMME mean and 1.67 LSE mean).

39

3.3.3 THEORY AND PRACTICE OF CAPITAL STRUCTURE

In the literature review, the Voulgaris et al. (2004) and other studies made

reference to different capital structure theories such as the static trade-off theory,

the information asymmetry theory, the pecking order theory, the agency cost

theory, the theory of finance on capital structure and debt structure that have

been empirically tested separately on SMMEs and LSEs by developing models

containing the factors that are expected to influence debt ratios. Only 33% of the

chief financial officers (managers) think capital structure theories are likely to

influence a firm‟s capital structure policies. However, the results show significant

scale effects from the ratios, specifically the gearing/debt ratios, also indicating

positive effects from variables such as size (measured as total assets) and the

percentage change in total assets as argued by Voulgaris et al., (2004: 248).

These results also prove that the other hypotheses (in this paper) are testable

with the asset structure (acting as collateral) being positively related to debt,

profitability being negatively related to debt and growth being positively related to

debt.

Size (measured as total assets) is positively correlated with total debt. Net

working capital (current assets less current liabilities) to total assets yielded

means of 1:5 for SMMEs and 1:45 for LSEs (20% of total assets); the long-term

debt plus net worth to net fixed assets ratio means were 2:1 and 1:1 for the

respective size groups and the indication of the asset structure (short-term debt

to total assets) means were 1:3 and 1:6 for SMMEs and LSEs respectively). This

is in line with the Ross 1977 information asymmetry theory (information about

activities of firms and future prospects known to managers is disseminated by

these managers to external stakeholders, exposing the managers‟ capital

structure choice). The assertion that the larger enterprises have better access to

bank financing than their smaller counterparts (as indicated by more fixed assets

acquired and generally extended total assets) is confirmed. Banks are able to

access the information divulged by managers on application for debt or when

40

financial statements are published and subsequently assess the enterprises‟

future prospects. When asked about what drives the choice between short- and

long-term debt, 67% of the managers‟ responded, rating the matching the

maturity of debt with the life of assets (very) important with means of 1 and 2 for

SMMEs and LSEs, respectively. This also confirms the importance of the asset

structure. However, the 33% importance rating on the extent to which different

stakeholders influence the firm‟s financial decisions shows that the managers

consider information asymmetry to be of a lesser significance.

The static trade-off theory explains how a firm decides on the debt-to-equity

ratio – on the assumption that some optimal capital structure exists, which

according to Miller (1988: 100), encourages firms to increase their debt levels.

On the factors that affect the appropriate amount of debt chosen by the firm, 50%

of the respondents to the questionnaire rated the potential costs of bankruptcy as

important whilst all the managers thought the tax advantage of interest

deductibility is very important. 100% of respondents also confirmed the tax

advantage of debt as an influencing factor to debt policy. The argument by

Voulgaris et al. (2004: 249) that a trade-off between tax gains and increased

bankruptcy costs increase a firm‟s cost of capital is, therefore, affirmed by the

responses.

The increase of debt is one of the factors associated with the growth (measured

as a percentage change in total assets) of a firm. The average change for

SMMEs is 35% whilst being 19% for LSEs. The change has been found to

significantly affect total debt through higher use of short-term debt than long-term

debt, especially by SMMEs (Voulgaris et al., 2004: 255). The authors‟ reasoning

is that SMMEs lack sufficient earnings to finance their needs due to difficulties in

accessing the capital market, hence the higher use of short-term debt in spite of

the maturity matching principle of finance. Growth is, therefore, positively

correlated to gearing. The Pecking Order theory has been aligned with growth

in that companies tend to hold large cash reserves instead of issuing stock

(Myers & Majluf, 1984: 194-195). The Kyereboah-Coleman (2007: 271) study

41

explains the theory to mean that firms prefer internal to external funding in terms

of the debt-equity mix. The high average 43% and 54% change in net profit for

the respective groupings is an indication of firms holding high retained income to

issue shares. This notion is supported by the responses when managers are

asked what factors affect the firm‟s decision when considering issuing equity.

For inability to obtain funds using other sources 17% thought it important

whereas no manager views stock the least risky source of funds. At the same

time the Myer‟s agency cost theory is also highlighted within the aspect of

selecting debt to equity. Because the managers are in possession of information

on the firm‟s future prospect, they tend to use the information for their personal

interests. When under pressure from shareholders and creditors, the managers

submit into using more debt. This signals the inability of the entities to meet

future cash obligations.

Profitability, measured as net profit to assets (return on assets) is a low 10% for

SMMEs and 8% for LSEs, was found to have a significant effect on short-term

and total debt (Voulgaris et al., 2004: 255). The effect is highlighted when a

comparison is made with the return on investment which is higher than the return

on assets due to the inclusion of borrowings in the latter. This negative

correlation to gearing is explained by the pecking order theory, which in the case

of SMMEs accessing debt and external equity would be very costly (Voulgaris et

al., 2004: 255). In case of LSEs the pecking order theory suggests that the firms

use debt only when additional finance is essential, with the trade-off theory not

holding (no unnecessary increase of debt). Gross and net profit margins do not

seem to affect short-term debt at 16% and 39% for SMMEs and 20% and 41%

for LSEs. Voulgaris et al. (2004: 256) point out that they would have significant

effect in long-term borrowing as they are determinants of this type of debt. It

should however, be noted that during the period under study, South African

interest rates were very high. The National Credit Act was also introduced in

June 2007 and as such firms were constrained in terms of accessing credit

facilities.

42

In line with the pecking order theory, net working capital to total assets, a proxy

for liquidity, was found to have a significant negative effect on total debt leverage

ratio (Voulgaris et al., 2004: 256). At 1:5 and 1:45 for SMMEs and LSEs

respectively, the remainder of working capital is too low and would not be

sufficient to cover debt.

The high employee contribution to sales production and higher total assets

growth is found to affect short-term borrowing. This signals the importance of

labour productivity and short-term debt for South African manufacturing SMMEs

(Voulgaris et al., 2004: 256). Empirical evidence, indicating the importance of

short-term finance to SMMEs, completes a number of papers with a Sunday

Times (2009-09-20: 10) article encouraging SMMEs to make use of appropriate

financial instruments to achieve their goals.

The significance of positive effects are also observed on long-term debt in terms

of liquidity, asset structure (fixed assets to total assets) and sales growth as

expected (Voulgaris et al., 2004: 256).

The Chen (2004: 1342) summarised effect of capital structure theories with the

empirical evidences on the relationship of capital structure determinants with

leverage has also been confirmed by the findings of this study.

3.4 CONCLUSION This chapter has tabled the computations of the twenty five ratios which had

been determined in highlighting the dependant (short-term and long-term debt)

and independent (profitability, growth, assets structure and size) variables.

These ratios have been analysed and interpreted in relation to their respective

means (averages).

43

Responses from the chief financial officers (managers) of the sampled

organizations were also analysed in relation to the variables. The empirical

results were then linked to the theories on capital structure to determine whether

there is correlation between the theories and the capital structure determinants

also to determine whether the correlation is of a positive or negative nature.

From the findings, the researcher has observed the existence of barriers to long-

term financing, especially for SMMEs. However, in the SME Survey 2009,

financial institutions are said to have had a relook into assisting SMMEs in terms

of opportunities, funding and advice (for example managing money collection,

streamlining stock holdings and negotiating better terms with suppliers (Sunday

Times, 2009-09-20: 10). The article further points out to initiatives focusing on

SMMEs in manufacturing and other sectors that are regarded as significant role-

players in the economy.

The next chapter on recommendations and conclusion will provide closing

remarks, commenting on, discussing and reporting the findings.

Recommendations on the way forward and policy proposal will be advanced.

This is then followed by the list of sources used in informing the study and the

subsequent appendices.

44

CHAPTER 4 4.1 SUMMARY OF FINDINGS

Several important conclusions can be drawn from the findings of this paper in as

far as the aspects of an entity‟s financial performance are concerned. In this

study the organizations‟ financial profile has been adequately substantiated, over

and above the published financial information. A company‟s financial profile

provides an indication of the company‟s viability in the short-term and long-term,

also referred to as the firm‟s value. In expanding the understanding of the

financials, ratio analysis has been applied. Central to the application of the

analysis are the capital and leverage structures of the entities, hence the focus

on both throughout the study. A comparison, in terms of financial performance

between Small, Medium and Micro Enterprises (SMMEs) and large size

enterprises (LSEs), features in the analysis.

Overall, the analysis confirmed previous researchers‟ observations that size

plays a role in liquidity, capital intensiveness as well as indebtedness. SMMEs

financial performance analysis revealed low solvency levels and low usage of

debt in general and long-term debt in particular. This size group leans on capital

availability which limits the group in accessing funds from lending institutions.

Effectively, the capital intensiveness of SMMEs results in these firms acquiring

less debt in comparison to LSEs which utilise the leverage (long-term debt).

The larger entities are able to secure credit as their extended asset structures

stand as collateral, widening the scope for more credit facilities. Net working

capital to total assets (a solvency/liquidity ratio) confirmed the points alluded to

above, also highlighting common attributes of revolving the same debt and

acquisition of assets on credit.

The analysis comprised of twenty-five ratios, grouped into clusters looking into

solvency/liquidity; profitability; managerial performance and growth. Of the

45

four computed solvency/liquidity ratios, three (current, quick (acid-test) and long-

term indebtedness) addressed the dependent variables: short- and long-term

debt as well as total debt. Profitability, managerial performance and growth,

representing explanatory (independent) variables, encompassed the rest of the

ratios. Profitability was measured in terms of three ratio categories: capital

turnover, profit margin and return on investment. Managerial performance was

assessed in terms of asset structure, inventory (holding periods), credit policy

and administration (personnel productivity). Growth was denoted by relative

changes in sales, total assets and net profits.

A holistic view of solvency/liquidity was expressed within a cash cycle context,

with the flow of cash linked with trading operations. SMMEs current ratio

showed ability of meeting short-term obligations, the inventory holding period

averaged higher than expected, accounts payable were delayed in lesser period

in comparison to that of the LSEs. LSEs in turn had a current ratio which

indicated that in the short-term current assets could easily cover current debt,

compensating for the longer inventory turnover period and accounts payable

delay of almost three months. With quick (acid-test) ratios, the analysis could

not provide a conclusive indication with the unavailability of accounts receivables

collection periods, proving the importance of not isolating any of the elements of

the cash cycle. The exclusion of (the high levels of) inventory in currents assets

(in the quick ratio calculation) could be the reason for downward change in

meeting the short obligations by both size groups. SMMEs quick ratio indicated

total inability to cover short-term debt whilst LSEs situation was better in that they

could just pay the short-term debt, though not as comfortably as recommended.

Net working capital remains at 20% of total assets for all the enterprises. The

remainder explained the retention of capital and profit in the case of SMMEs

whilst pointing to the extended use of credit in acquiring assets for LSEs. Else

both size groups are revolving the same debt. Long-term debt plus net worth

to net fixed assets proved that SMMEs long-debt would not be payable from

non-current assets and are susceptible to liquidation whilst the different sized

46

LSEs would be in control of the situation. The exclusion of current liabilities from

equity warns on the extent of indebtedness which could explain the state of

SMMEs, The LSEs fixed assets, obtained by means of long-term debt, provides

a balance this ratio to acceptable limits, yet SMMEs do not enjoy the luxury of

collateral in exchange of extended credit.

Profitability assesses profits in relation to sales generated, assets and equity

within the same period. Appropriate capital investment percentage of sales to

net fixed assets or working capital or total assets or equity (capital

turnover), proved to be higher for SMMEs than for LSEs in 75% of the ratios, an

indication of the latter‟s high use of long-term debt in contrast to the former‟s

investment in capital. Whether borrowings are included or not, return on

investment of SMMEs was higher than the LSEs, also confirming the reliance on

capital by SMMEs versus reliance on borrowed funds by LSEs. Profit margin

ratios averaged low for both SMMEs and LSEs at 10% and 8%, respectively, an

attribute to low sales prices, high cost of sales and period costs as well as the

probable effects of the recession in the latter years. The argument is

substantiated by the subsequent gross profit to sales and net profit to gross

profit ratios which were higher, more for LSEs. The LSEs low profit margins

could be traded off against the higher asset turnover – assets acquired by means

of long-term debt, yet the SMMEs are limited in accessing debt finance, hence

the lower asset turnover.

Managerial performance was guided by a larger number of classes, including

solvency/liquidity. These classes covering asset structure, inventory, credit

policy and administration, were measured by means of nine ratios, with the

asset structure and administration being the only classes not already discussed

in solvency/liquidation above. Long-term debt to total debt, as a measure of

the asset structure was the same for both size groupings, securing interest

coverage by the generated profits. Findings of more ratios within this category

reflected the same arguments in terms of capital intensiveness of SMMEs

47

(capital to equity), high at 1097:1 and LSEs collateral theories in terms of the

short-term debt to total assets fairing higher than that of SMMEs. Different

employment figures impacted on the administration productivity analysis for the

different sized organizations, with the expected conclusion that the LSEs ratios

would be significantly different to those of the SMMEs.

Growth

The significant increases in sales, total assets and net profits signalled positive

growth in both the SMMEs and LSEs. Findings showed an above average

(+20%) upward trend of 26% and 20% sales respective increases in spite of

profit margins. The element of change in total assets was as a consequence of

asset acquisitions (LSEs), as evidenced in asset structures as well as a change

in retained earnings (SMMEs). Net profit change was caused by the revenue

changing relative to assets. The trade-off argument, that when profit margins are

high asset turnover is lower and vice versa, therefore, fitted in this respect.

Also found to be relative are two main considerations which, according to the

facts, have been proven to influence capital structure decisions of the surveyed

chief financial officers (managers): the theory and practice of capital

structure and the impact of the debt policy. Both considerations entail

financial flexibility, a key factor for the managers in accessing external financing

whatever the economic outlook. The experience of the recession has

strengthened the need to investigate the use of leverage by companies.

Empirical evidence on the role of the determinants of capital structure,

documented in a number of studies, had to be reviewed within the context of the

credit crunch.

48

Relevance of financial policy regarding debt:

Recognising that taking financial decisions are their sole responsibility, chief

financial officers or managers strongly supported the aspects of maintaining

target debt-to-equity ratios, considering whether recent profits are sufficient

and the timing of debt or equity issuing. The three points sought to address the

theory and practice of the capital structure, funding activities and factors likely to

influence capital structure policies for which these managers have to account.

As a result, the managers neither regard stakeholder influence in financial

decisions as effective nor do they think the inability in obtaining funds is much of

a deterrent. Stock/inventory could not be taken to be the least risky source of

funds. Amongst the criteria of debt policy, regarded as very important, was the

choice of an appropriate amount of debt, taking advantage of interest in terms of

tax shields and the timing of the debt/equity issue. Not only does this principle

make good business sense but it also underscores good management practices,

one of the variables in the analysis. Regarded as less important was the

matching of debt with asset life span (in the short-term) as well as the issuing of

short-term to delay long-term debt obligations.

This paper‟s findings reflected not only the impact of the recession but also the

transitional nature of the South African corporate environment, exposing the lack

of adequate legislation in support of the ultimate growth and sustainability of the

companies, especially the SMMEs. Suggesting the re-visitation of legislation

around the SMMEs, guarding against isolating the LSEs, was necessary. To

reserve resources, it has been important to first identify commonalities and

differences, if any, between the two size groups.

Panel data of the sampled SMMEs and LSEs from the manufacturing sector of

the Gauteng province, South Africa, were used in testing the hypotheses and

answering the research question. Empirical evidence from the case study

undertaken suggest that the determinants of capital structure of the two size

49

groups do differ whereas there are also factors that are consistent. Among the

latter, having been acknowledged by previous works, were the following:

debt / leverage (dependant variable) increases with size (the main

explanatory variable). The analysis suggests that LSEs employ more

long-term debt and debt in general, in comparison with their smaller

counterparts. The latter prefer short-term finance hence the lower

amounts of long-term debt. Significant institutional differences such as

ownership and financial constraints in the banking sector are factors that

influence firms leverage decisions.

debt has a negative relationship with profitability as assumed in the

pecking order theory framework, implying that high profitable firms

generate high internal cash flows to finance their investments.

growth (percentage increase in total asset) shows a higher utilisation of

total debt, specifically through higher short-term debt. Entities with high

growth require more external financing to finance their growth, displaying

higher leverage. The firms use more total liabilities but use less long-

term debt.

As witnessed in the elements listed above, leverage has featured as a key

element on which the optimal capital structure is based, which is consistent with

the view that without debt financing a firm value is regarded as lower than that of

firms with debt financing.

Fundamental differences between small and large firms have also been

identified, confirming that size significantly impacts on the capital structure choice

specifically the use of debt. Now and then evidence emerged in favour of the

existence of leverage constraints for long-term financing, especially for SMMEs.

50

Other differences summarised, include:

Liquidity not affecting LSEs debt leverage as opposed to SMMEs. LSEs

have assets as collateral to secure debt, compared to their counterparts.

Also in relation to debt leverage, the LSEs accumulation of assets does

affect the amount of their financial liabilities, which is not the case with

SMMEs.

The size of fixed assets and employee productivity has not indicated

significance as determinants of LSEs‟ capital structure, as in SMMEs.

Inventory management, which reflects on management (in)efficiencies are

found to be determinants of debt only for SMMEs.

4.2 IMPLICATIONS OF EXISTING THEORY

The literature had shed light in terms of the theoretical framework tabled by

previous researchers. The findings of this study concur with the fact that there is

a linkage between the variables prescribed in this study (dependant and

explanatory variables) and the theorems. The existence of a relationship

between firm size and total leverage, based in the information asymmetry

theory, is realised when information privy to managers is utilised by the financing

institutions, hence the discrepancies in lending facilities. Exposure of LSES

asset structures gives these enterprises more advantage with regard to funding.

In pursuit of growth, firms have been found to be increasing their debt levels (with

the subsequent debt-to-equity ratio), as the static trade-off theory predicts. The

benefits of debt (in tax deductibility) outweighed the transactional costs (interest

payable), as submitted by respondents to the questionnaire, concurring that the

factor was influential to the debt policy. Arguments on the pecking order theory,

the agency cost theory, the theory of finance on capital structure and debt

structure have also been confirmed in the tests. Also in terms of growth

opportunities, the pecking order model implies the reluctance by organizations

51

in issuing stock preferring to issue debt. An overwhelming percentage of chief

financial officers (managers) concurred with the idea.

However, the notion of the pecking order model contradicts the desire for

financial flexibility as the interests of the firms‟ owners are not positively served

(in terms of dividends). This highlights the theory on agency costs which is

also consistent in that managers are conflicted in choosing debt over equity. The

asset structure is also collated positively to debt as it signals the company‟s

ability to meet its credit obligations, allowing the financier to provide more credit.

Signalling also affects capital structure choice.

The opposite is evidenced when it comes to profitability, with results showing a

negative correlation between this independent variable and aspects of the theory

of finance on capital structure and leverage.

4.3 RECOMMENDATIONS

The empirical results presented in this study have some implications for

policymakers (within and outside of the entities), as some theoretical

underpinnings of the observed correlations remain unresolved. In order to assist

South African manufacturing firms obtain optimal capital structure, the following

policy measures are suggested:

Change the attitude of banks towards small sized firms so that they

provide easier access to long-term bank financing. This will encourage

growth of the SMMEs and the subsequent expansion of the manufacturing

industry as a whole.

Support government support as required in terms of financing by reviewing

the existing restrictions which are detrimental to SMMEs, providing

assistance in raising capital, capital schemes and loan subsidies. Growth

and sustainability of these entities is vital for the economy.

52

Support government support as needed in terms of services: information

measures in support of co-operation of both size groups, locally, regionally

and internationally. Exposure of these firms expands their networks,

resulting in global competitiveness.

State guarantees for SMME investment in new technology should be

provided. This will enhance the competitiveness, facilitating growth and

export.

SMMEs should be encouraged to use alternative financial instruments to

broaden access to finance even beyond the country. Transparent trading

operations expand markets.

Benchmarking of national policies in support of the Broad Based Black

Economic Empowerment strategies which are intended to empower

SMMEs.

Review of tax laws in terms of tax rates decreases and tax alleviation

enabling smaller firms to be self-sufficient and be debt healthy.

Promulgation of policies aiming at supporting all firms in research and

development, marketing and promotion, nationally and internationally.

Policies that will assist South African firms in corporate governance to

achieve a stronger capital structure. Inefficient corporate governance

structures exacerbate the prevailing agency problems, with managers

taking advantage of the situation.

Measures directed towards deregulation of markets and restrictions of the

public sector which would result in an increase in economic activity

improving efficiency of South African firms. These flexible by-laws should

be applicable in instances of disasters where the economy needs to be

boosted afterwards. An example of such legislation is government

intervention by means of bail-outs to companies.

53

Ensuring effectiveness and efficient implementation of the policy

formulation suggested above in order to improve the financial performance

of the manufacturing sector in South Africa.

Internally, companies should

use retained income in financing new investments and operational costs.

With the current financial crisis in mind, South African firms must increase

their cash generating capacity through more efficient asset management;

increase competitiveness within the continent and global markets;

increase cash generating capacity;

establish good and steady bank-firm relations;

provide highly trained managerial personnel, trained in technologies in

personnel in accordance with the new global trends.

4.4 SCOPE FOR FUTURE RESEARCH

Although this study has not been based on action research, there are important

implications regarding academic curricula hence the recommendations below to

academia and potential researchers.

- Restructuring of academic programs in the country is essential. The

programmes should be diverse and focused especially in areas

specialising in financial management.

- Designing a model in which optimal capital structure and debt maturity are

jointly determined.

This paper has laid some groundwork to explore size and other determinants of

capital structure of South African listed manufacturing companies upon which a

54

more detailed evaluation could be based. Further work can be undertaken in

order to develop new hypotheses for the capital choice decisions in (with regards

to leverage) these South African firms and to design new variables to reflect the

institutional influence(s).

55

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APPENDIX A

(Survey Questionnaire)

NAME:………………………………………………………………………………

COMPANY NAME:…………………………………………………………………

DESIGNATION:………………………………………………………………………

Please rate on a scale of 0 (irrelevant) to 4 (very important). Circle the number that best reflects your choice

Irre

levant

Unim

port

ant

Neutr

al

Import

ant

Very

im

port

ant

A. THEORY AND PRACTICE OF CAPITAL STRUCTURE:

1. The extent to which different stakeholders influence the firm‟s financial decisions

0 1 2 3 4

2. Factors likely to influence firm‟s capital structure policies:

2.1 Capital structure theories 2.2 Managers‟ timing of debt or equity issues 2.3 Capital structure changes on financial statements

0 0 0

1 1 1

2 2 2

3 3 3

4 4 4

3. When your firm considers issuing equity, what factors affect its decisions about equity?:

3.1 Maintaining a target debt-to equity ratio 3.2 Whether recent profits are sufficient to fund activities 3.3 Inability to obtain funds using other sources 3.4 Stock is the least risky source of funds

0 0 0 0

1 1 1 1

2 2 2 2

3 3 3 3

4 4 4 4

B. DEBT POLICY:

4. How the appropriate amount of debt is chosen for the firm 0 1 2 3 4

5. Factors that influence debt policy:

5.1 Tax advantage of debt 5.2 Timing of debt/equity issue

0 0

1 1

2 2

3 3

4 4

6. Choice between short-term and long-term debt 0 1 2 3 4

59

Please rate on a scale of 0 (irrelevant) to 4 (very important). Circle the number that best reflects your choice Ir

rele

vant

Unim

port

ant

Neutr

al

Import

ant

Very

im

port

ant

7. What drives the choice between short-term and long- term debt?:

7.1 Matching the maturity of debt with the life of assets 7.2 Borrowing short-term to reduce the chance of taking on risky projects 7.3 Issuing long-term debt to minimize the risk of financial “bad times” 7.4 Issue short-term while waiting for long-term market interest rates to decline

0 0 0

1 1 1 1

2 2 2 2

3 3 3 3

4 4 4 4

8. What factors affect how the appropriate amount of debt is chosen for the firm?

8.1 Financial flexibility 8.2 The tax advantage of interest deductibility 8.3 The potential costs of bankruptcy 8.4 Ensuring that upper management works hard and

efficiently

0 0 0 0

1 1 1 1

2 2 2 2

3 3 3 3

4 4 4 4

9. What other factors affect your firm‟ debt policy?

9.1 Debt is issued when recent profits are not sufficient for funding activities

9.2 Debt is issued when the firm has accumulated profits

0 0

1 1

2 2

3 3

4 4

(Adapted from: Bancel & Mittoo, 2004)

60

APPENDIX B Table I: Summary statistics of dependent and independent variables: 2004 - 2008

SMMEs LSEs

Mean Median Mean Median

SOLVENCY/LIQUIDITY

Short-term debt: Current ratio Quick ratio Net working capital total assets

1:1 1:2 1:5

1:1 1:1 1:6

2:1 1:1

1:45

1:1 1:1 1:9

Long-term debt + net worth to net fixed assets

2:1

1:1

1:1

1:1

MANAGERIAL PERFORMANCE

Asset structure: Long-term debt to total debt Total debt to total assets Net worth to long-term capital Short-term debt to total assets

1:3 1:2

1 097:1 1:3

1:1 1.2 1:2 2:1

1:3 1:2

104:1 1:6

1:1 1:2 1:2 1:1

Inventory to sales (in days) 77 63 83 64

Accounts payable to sales (in days 54 51 84 62

Administration R434 952 R219 527 R715 R644

GROWTH

% change in sales % change in total assets % change in net profit

26% 35% 43%

20% 29% 37%

20% 19% 54%

19% 15% 51%

PROFITABILTY

Profit margin: Net profit to gross profit Net profit to sales Gross profit to sales

39% 10% 16%

25% 6% 17%

41% 8% 20%

39% 6% 21%

Return on investment: Net profit to net worth Net profit to total assets

22% 10%

19% 9%

16% 8%

11% 4%

Capital turnover: Sales to net fixed assets Sales to net working capital Sales to total assets Sales to net worth

271% 417% 117% 191%

199% 276% 107% 260%

202% 288% 107% 255%

116% 280% 80% 274%

61

Table A1 SOLVENCY

SMMEs

LSEs

Mean Median

Mean

Median

Short-term:

Current assets to current liabilities 2004 1 : 1 1 : 1

2 : 1 1 : 1

2005 2 : 1 1 : 1

1 : 1 1 : 1

2006 2 : 1 1 : 1

1 : 1 1 : 1

2007 1 : 3 1 : 1

1 : 1 1 : 1

2008 1 : 1 1 : 1

2 : 1 1 : 1

Quick asset to current debt 2004 1 : 2 1 : 1

1 : 1 1 : 1

2005 1 : 1 1 : 1

1 : 1 1 : 1

2006 1 : 2 1 : 1

1 : 1 1 : 1

2007 1 : 1 1 : 1

1 : 1 1 : 1

2008 1 : 1 1 : 1

1 : 1 1 : 1

Net working capital to total assets 2004 1 : 2 1 : 4

1 : 17 1 : 6

2005 1 : 2 1 : 4

1 : -9 1 : 7

2006 1 : 3 1 : 5

1 : 13 1 : 12

2007 1 : 1 1 : 2

1 : 7 1 : 13

2008 1 : 15 1 : 17

1 : 142 1 : 6

Long-term:

Long-term debt + net worth to net

fixed assets 2004 1 : 1 1 : 1

1 : 1 1 : 1

2005 2 : 1 1 : 1

1 : 1 1 : 1

2006 1 : 1 1 : 1

1 : 1 1 : 1

2007 1 : 1 1 : 1

1 : 1 1 : 1

2008 1 : 1 1 : 1

1 : 1 1 : 1

62

Table A2 GROWTH

SMMEs

LSEs

Mean Median

Mean Median

Percentage change in sales 2004 19.4% 17.8%

9.9% 10.8%

2005 8.3% 9.0%

21.2% 16.5%

2006 39.2% 23.9%

6.7% 22.1%

2007 38.2% 69.6%

40.9% 29.3%

2008

Percentage change in total assets 2004 23.8% 23.5%

13.8% 3.4%

2005 34.2% 27.6%

17.8% 17.8%

2006 57.0% 30.1%

17.9% 22.7%

2007 24.6% 53.3%

27.2% 13.5%

2008

Percentage change in net profit

2004 65.2% 65.0%

20.2% 50.5%

2005 24.9% 28.2%

117.4% 83.3%

2006 8.9% 3.7%

644.6% 5.6%

2007 72.1% 46.5%

25.6% -18.8%

63

Table A3 PROFITABILITY:

SMMEs

LSEs

Capital turnover:

Mean Median

Mean Median

Sales to net fixed assets 2004 420.9% 226.1%

201.3% 107.7%

2005 379.0% 238.5%

206.0% 115.9%

2006 195.3% 199.4%

192.4% 105.0%

2007 186.5% 186.0%

188.7% 120.2%

2008 172.8% 191.4%

221.0% 149.4%

Sales to net working capital 2004 340.6% 299.3%

256.8% 267.3%

2005 357.0% 321.4%

270.8% 246.4%

2006 316.4% 276.2%

308.5% 279.8%

2007 838.7% 232.0%

295.1% 319.0%

2008 234.3% 233.4%

310.0% 317.1%

Sales to total assets 2004 143.5% 122.4%

105.4% 80.0%

2005 138.1% 122.0%

110.2% 83.6%

2006 107.6% 107.0%

108.1% 76.1%

2007 100.2% 102.4%

97.4% 79.5%

2008 95.3% 91.0%

115.2% 88.3%

Sales to net worth

2004 344.1% 346.0%

257.9% 227.8%

2005 293.0% 271.5%

249.9% 298.2%

2006 251.5% 221.6%

241.9% 274.0%

2007 265.9% 259.6%

235.8% 221.7%

2008 299.5% 216.9%

288.6% 324.4%

64

SMMEs LSEs

Mean Median Mean Median

Profit margin:

Net profit to gross profit 2004 20.2% 20.2% 35.3% 30.1%

2005 48.1% 48.1% 18.2% 35.8%

2006 54.5% 54.5% 43.2% 38.9%

2007 37.4% 25.0% 67.5% 55.5%

2008 36.7% 20.9% 40.9% 27.1%

Net profit to sales 2004 6.2% 6.0% 4.8% 4.1%

2005 9.2% 8.6% 3.9% 5.9%

2006 9.8% 10.8% 9.0% 10.0%

2007 8.0% 5.2% 9.1% 8.6%

2008 14.3% 4.3% 13.3% 4.1%

Gross profit to sales 2004 8.3% 0.0% 18.0% 12.6%

2005 12.9% 12.5% 18.3% 16.8%

2006 10.9% 8.9% 20.8% 21.0%

2007 19.6% 25.0% 17.7% 22.3%

2008 30.3% 21.3% 25.4% 16.0%

65

SMMEs LSEs

Mean Median Mean Median

Return on investment:

Net profit to net worth 2004 18.8% 17.2% 12.5% 6.5%

2005 20.4% 22.6% 10.9% 4.6%

2006 19.6% 19.1% 18.7% 12.6%

2007 16.5% 17.4% 17.8% 11.9%

2008 34.2% 21.4% 18.7% 11.3%

Net profit to total assets 2004 8.0% 8.5% 5.3% 4.0%

2005 10.1% 9.3% 5.9% 2.1%

2006 9.1% 9.8% 9.6% 6.6%

2007 7.3% 5.9% 8.4% 5.7%

2008 13.2% 5.3% 10.1% 7.7%

Inventory:

Inventory to sales (days) 2004 55 55 84 64

2005 81 82 83 58

2006 85 85 68 67

2007 87 63 64 53

2008 70 58 116 75

66

SMMEs LSEs

Mean Median Mean Median

Credit policy:

Accounts payable (creditors) to

sales 2004 47 49 118 64

2005 43 51 116 61

2006 53 46 71 69

2007 67 63 60 62

2008 62 58 56 48

Administration:

Sales to number of employees

2004 307 822 211 256 919 504

2005 339 112 219 527 968 572

2006 359 303 288 476 1 071 644

2007 491 996 479 701 1 175 786

2008 679 530 28 802 1 482 1 071

67

TABLE A4

MANAMANAGERIAL PERFOMANCE

SMMEs: Mean Median

LSEs:

Mean Median

Assets structure:

Current assets to current liabilities 2004 1 : 1 1 : 1 2 : 1 1 : 1

2005 2 : 1 1 : 1 2 : 1 1 : 1

2006 2 : 1 1 : 1 1 : 1 1 : 1

2007 1 : 3 1 : 1 1 : 1 1 : 1

2008 1 : 1 1 : 1 1 : 1 1 : 1

Long-term debt to total debt 2004 1 : 5 1 : 3 1 : 3 1 : 2

2005 1 : 3 1 : 3 1 : 4 1 : 5

2006 1 : 2 1 : 2 1 : 3 1 : 2

2007 1 : 3 1 : 3 1 : 3 1 : 2

2008 1 : 3 1 : 2 1 : 3 1 : 2

Total debt to total assets 2004 1 : 2 1 : 2 1 : 2 1 : 2

2005 1 : 2 1 : 2 1 : 2 1 : 2

2006 1 : 2 1 : 2 1 : 2 1 : 2

2007 1 : 2 1 : 2 1 : 2 1 : 2

2008 1 : 2 1 : 2 1 : 2 1 : 2

Net worth to long term-capital 2004 769 : 1 2 : 1 3 : 1 1 : 1

2005 965 : 1 2 : 1 3 : 1 1 : 1

2006 1330 : 1 3 : 1 5 : 1 2 : 1

2007 1131 : 1 2 : 1 56 : 1 1 : 1

2008 1292 : 1 12 : 1 456 : 1 2 : 1

68

Short-term debt to total assets 2004 1 : 3 1 : 3 1 : 5 1 : 3

2005 1 : 3 1 : 3 1 : 4 1 : 3

2006 1 : 4 1 : 3 1 : 5 1 : 3

2007 1 : 3 1 : 3 1 : 5 1 : 3

2008 1 : 3 1 : 3 1 : 5 1 : 3

69

Table II:

SURVEY REPORT

Respondents are asked to rate on a scale of 0 (irrelevant) to 4 (very important). The report is on the mean of the different size groups; SMME‟s and LSE‟s, as well as percentage (%) of respondents that answered 3 and 4 (important and very important).

Survey question Important or very SMME LSE important % Mean Mean

A. THEORY AND PRACTICE OF CAPITAL STRUCTURE: 1. The extent to which different stakeholders influence the firm‟s financial decisions 33% 1 1

2. Factors likely to influence firm‟s capital structure policies:

2.1 Capital structure theories 33% 1 1 2.2 Managers‟ timing of debt or equity issues 67% 1 1 2.3 Capital structure changes on financial statements 33% 1 1

3. When your firm considers issuing equity, what factors affect its decisions about equity?:

3.1 Maintaining a target debt-to-equity ratio 100% 1 2 3.2 Whether recent profits are sufficient to fund activities 100% 1 1.67

3.3 Inability to obtain funds using other sources 17% 1 1 2 3.4 Stock is the least risky source of funds 0% 1 1.25 Survey question Important or very SMME LSE important % Mean Mean

70

B. DEBT POLICY: 4. How the appropriate amount of debt is chosen for the firm? 33% 3 1.5

5. Factors that influence debt policy: 5.1 Tax advantage of debt 100% 1 1 5.2 Timing of debt/equity issue 100% 1 1

6. Choice between short-term and long-term debt 50% 1 1.33

7. What drives the choice between short- and long-term debt?:

7.1 Matching the maturity of debt with the life of assets 67% 1 2 7.2 Borrowing short-term to reduce the chance of taking on risky projects 17% 1 1.67 7.3 Issuing long-term debt to minimize the risk of financial “bad times” 17% 1 1.67 7.4 Issue short-term while waiting for long-term market interest rates to decline 67% 2 4

8. What factors affect how the appropriate amount of debt is chosen for the firm?:

8.1 What factors affect how the appropriate amount of debt is chosen for the firm? 100% 2 4 8.2 The tax advantage of interest deductibility 100% 2 4 8.3 The potential costs of bankruptcy 50% 1 1 8.4 Ensuring that upper management works hard and efficiently 67% 1 1.33

9. What other factors affect your firm‟s debt policy?;

9.1 Debt is issued when recent profits are not sufficient for funding activities 0% 1 1.67 9.2 Debt is issued when the firm has accumulated profits 33% 1 1

71

APPENDIX C