The effect of debt financing on profitability: evidence from the financial crisis Master’s

Abstract

This thesis examines the causality of leverage on companies’ profitability around the financial crisis of 2008. Leverage is defined as total debt of company divided by its total assets, while profitability is companies’ net profit after all costs are deducted. In addition, the effect of companies’ age on the causality is studied. Dataset contains approximately 9000 Finnish small and medium sized companies from years 2005 to 2013. Time period is divided into two periods, a pre crisis period for years up to 2008, and post crisis for years after 2008. A panel data regression is used to conduct the tests.

Empirical results show that there is a statistically significant and positive causality of leverage on profitability, that is present in both pre and post crisis periods. For smaller companies, the effect is stronger in pre crisis period, while for medium sized companies the causality grows more positive after the crisis. Additional dummy variable indicating grown absolute debt in year n-1 is also significant and positive, and again showing stronger effect on smaller companies and on pre crisis period. For small companies, the dummy of increased debt has a higher impact on profit than the leverage variable during post crisis period, highlighting the benefit of low interest rate debt in crisis aftermath. Increased debt is not significant for medium sized companies on post crisis period. Regarding age, companies with age of 10 years or less have stronger causality between leverage and profit on smaller companies, but for medium sized companies the result is the opposite.