Capital structure : profitability, earnings volatility and the probability of financial distress

Abstract

This research project set out to determine whether there is a relationship between the observed leverage levels of South African companies, their profitability, earnings volatility and the probability of financial distress. The relevant body of knowledge against which to execute this research project is known as capital structure theory. Capital structure theory deals with the way in which firms finance themselves. It is concerned with the relationship between the structure of debt, equity and hybrid securities found on the right hand side of the firm’s balance sheet. It is believed that the 2007/8 global financial crisis offers researchers a unique opportunity to gain insight into how the observed leverage levels of firms and their earnings volatility interact to form their probability of financial distress. This area of research is of particular interest since it is commonly believed and frequently stated that South African firms are underleveraged and secondly because there is contrarian research beginning to be published indicating that firms with very little or no debt (commonly referred to as lazy balance sheets) are outperforming their more indebted peers and are being rewarded by investors for their prudence. Copyright