THE ROLE OF FINANCIAL LEVERAGE IN SHAPING PROFITABILITY: A STUDY OF PAKISTAN’S NON-FINANCIAL SECTOR
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Abstract
Pakistan’s corporate sector, characterized by an emerging economy, shallow equity markets, and concentrated family ownership, remains strongly dependent on debt financing. While borrowing can facilitate expansion, high leverage becomes problematic during economic instability, elevating the risk of financial distress. Current study analyzes how financial leverage influences the performance of non-financial firms listed on the Pakistan Stock Exchange (PSX), with a particular focus on coverage ratios that reflect firms’ capacity to service debt rather than relying solely on leverage levels. Using purposive sampling, data were collected for more than 200 firms from major sectors including textiles, cement, chemicals, automobiles, and energy over the period 20002023. To address endogeneity and ensure credible estimates, the analysis employs Random Effects models and the Two-Step Robust System GMM approach. Results show that the Interest Coverage Ratio (ICR) has a positive and significant effect on both Return on Assets (ROA) and Return on Equity (ROE), underscoring the importance of earnings strength in managing debt. In contrast, the Debt Service Coverage Ratio (DSCR) exhibits a significant negative association with firm performance, reflecting the strain of principal repayment commitments. The findings also indicate that COVID-19 and Pakistan’s Economic Policy Uncertainty (EPU) intensify the risks tied to high leverage. Overall, the study offers evidence from a volatile emerging market and provides insights for managers seeking to optimize capital structure and for policymakers aiming to enhance corporate stability.
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