THE 10th ISLAMIC BANKING, ACCOUNTING AND FINANCE INTERNATIONAL CONFERENCE 2022
(iBAF 2022)
Does COVID-19 Affect A Firm’s Debt Level? Evidence From Shariah-Approved Firms in Malaysia (A Conceptual Framework)
(Extended Abstract)
Nurshamimitul Ezza Ramli, Nur Ainna Ramli and Norasikin Salikin
Faculty of Economics & Muamalat Universiti Sains Islam Malaysia (USIM)
E-mail: nurainna.ramli@usim.edu.my (corresponding author)
1. INTRODUCTION
Debt demands a company to make a long-term financial commitment. Therefore, a variety of uncertainties throughout the financing period may have an impact on a company's capacity to honour its commitments.
Numerous elements, such as the economy, industry, politics, inadequate management, and other unforeseen circumstances, can contribute to uncertainty. The hit of the COVID-19 pandemic worldwide in the year 2019 also has changed a business’s landscape. To respond to any unanticipated incident, businesses must carefully plan how to manage their debt obligation because failure to do so could quickly lead to bankruptcy.
Statistically, after the hit of the COVID-19 pandemic, the Malaysian non-financial corporate (NFC) sector’s outstanding debt grew by 3.8% annually to RM1.6 trillion or 108.1% of GDP as of June 2020 as in Figure 1. It was mainly attributed to lower repayments due to the moratorium and an increase in working capital loans (Central Bank of Malaysia, 2020). Further, in the same report, it was stated that the aggregate new loans disbursed to the NFC also declined by 3.4% as demand for financing moderated sharply and banks re-assessed business sector risks.
Figure 1: Malaysia’s Corporate Debt-to-GDP Ratio Source: Bank Negara Malaysia (2020)
This figure is concerning because we are aware that debt contributed to the failure of Amercan corporations like Enron in 2001 and Lehman Brothers in 2008. These increasing trends have raised further concerns, as financial crises in many emerging countries have been preceded by rapid growth in debt levels (International Monetary Fund, 2015). Therefore, intensive research that examines firms’ debt determinants and factors that influence a firm’s debt level is really in need, especially under the current unanticipated business landscape. At least, we try to prevent history from repeating itself, at least for corporate firms in Malaysia.
Looking at the current global economic condition that is still recovering after the attack of the COVID-19 pandemic that starts in the year 2019, this study is keen to explore further on examining whether the COVID-19 pandemic does affect the capital structure decision by focusing on the Shariah-approved firms in Malaysia. The study developed a conceptual framework to determine whether the COVID-19 pandemic affect the Shariah- approved firm’s debt level in Malaysia for analysis from 2000 until 2021.
Prior studies that focus on the impact of COVID-19 on Shariah-approved firm’s debt levels in Malaysia setting particularly, is currently lacking. This is maybe due to most of the studies keen to focus on the impact of COVID- 19 on financial institutions and firms’ performance. However, several papers are worth mentioned for. Mohd Azhari, Mahmud and Sara Naquia Hanim (2022) in their research found that the capital structure of Malaysian companies has changed slightly during the COVID-19 period. During the COVID-19 period, short-term debts and total debts have both decreased slightly. However, long-term debts have increased marginally. Interestingly, the factors that influenced the firms’ capital structure that is proxied by total debt are the same before and during COVID-19 comprises of profitability, tangibility, liquidity and size.
Huang and Ye (2021) further assert that many firms, particularly those with significant leverage, may face financial distress as a result of COVID-19’s negative influence on their financial health. This is because low- leverage and profitable businesses have easier access to debt funding as they are assumed to have greater financial flexibility. However, firms will be exposed to increased risk as their reliance on debt financing grows.
2. UNDERLYING THEORIES OF CAPITAL STRUCTURE
The modern capital structure theories came into existence after the seminal works of Modigliani and Miller (1958) of a well-known capital structure irrelevance theory of MM I and MM II. The MM theorem assumes that in a perfect capital market, the value of the firm is independent of any form of capital structure. The MM also assumes similar business risks among firms operating in a similar business environment and firms are also assumed to pay no tax with zero transaction cost.
The above argument has initiated debates among researchers where the firm value of being independent of the capital structure may encourage 100% debt to maximize their shareholder profit. This may lead to higher bankruptcy risk should there be a default in loan repayment. Researchers also argue that in reality, the economy is operating in an imperfect capital market and the value of firms is determined not only by looking at debt and equity but also the consideration of other factors too such as taxes, transaction costs, bankruptcy costs, agency conflicts, adverse selection, lack of separation between financing and operations, time-varying financial market opportunities, and investor clientele effect (Frank and Goyal, 2008). Arguments and counter-arguments raised from the MM theory have led to the development of other capital structure theories such as the trade-off theory (TOT), the pecking order theory (POT) and the agency theory.
2.1 The trade-off theory (TOT)
The original TOT was derived from the MM theorem of Modigliani and Miller (1958) and Modigliani and Miller (1963). The TOT is looking at the cost and benefit of debt. By opting for debt, firms can reap the tax shield advantage that comes with debt employment, where the higher the level of debt employed the bigger tax shield it will enjoy. Firms are expecting lower tax liability and thus increase the after-tax cash flow or profit. In other words, firms prefer high debt financing to reap the tax shield advantage.
2.2 The pecking order theory (POT)
The early development of the POT begins with the study of Donaldson (1961) on the financing practices of a sample of large corporations. This then drives Myers and Majluf (1984) and Myers (1984) to extend further and introduce the POT. The POT is hierarchical financing with internal financing being the first option of financing as compared to external financing. The POT is derived from the asymmetric information problem. The managers of a firm are believed to have more information and access to the real value of the firm’s assets and growth opportunities in comparison to the shareholder. As such, in the event of the stock price being overvalued, the firms will issue new stock to raise capital as the issuance of new stock transfers the value from new investors to the existing shareholders of the firms. On the other hand, when the stock is undervalued, the firms would opt for debt instead of issuing new equity to minimize the bargain handed to new investors.
However, the POT does not always hold true to explain the firm’s preferences in choosing their financing mode. Leary and Roberts (2010) share evidence of firms violating the hierarchy of either by issuing external securities when internal resources are sufficient or by issuing equity in place of debt. Vasiliou, Eriotis and Daskalakis (2009) suggest that even with a significant difference between the number of firms that preferred retained earnings and firms that preferred long-term debt or the issuance of new stocks, the ordering of debt and equity is not determined, thus the POT influence is not significant. In addition to that, the methodological weaknesses during the analysis may also lead to inappropriate conclusions.
2.3 The agency theory
The agency theory initiated by Jensen and Meckling (1976) is an extension of the earlier work of Fama and Miller (1972). Agency conflict may occur between the stockholders and the managers and between the stockholders and the debt holders. There have been arguments proposed by previous literature regarding the linkages between the agency conflict and the capital structure choice like the high bargaining power of debt holders (Yu, 2012), human capital protection (Fama, 1980) and to avoid pressure from the interest payment (Jensen, 1986).
2.4 Islamic perspective on the firm’s debt level
It is also interesting to discuss further the perspective of Islam on debt as Islam does recognize debt contracts.
Even, our prophet Muhammad s.a.w (p.b.u.h) himself also incurred debt. However, in Islam, lending is considered a benevolent act to help people in need. Thus, debt in Islam will always refer to the qardul hassan or charitable contract. Since the aim of this contract is to help the needful people, thus no interest (riba’) will be charged to the borrower. The act of lending without expecting any return is just for the sake of getting Allah’s blessing (barakah) and upholding the spirit of helping each other (ta’awun). In Islam, the level of debt is benchmarked by following the Prophet Muhammad s.a.w (p.b.u.h) words that 33% or 1/3 is enough. This is evidenced by the hadith narrated by Bukhari and Muslims.
In existence, literature relating to the Islamic capital structure is scarce and limited. However several kinds of literature are worth discussing. Ahmed (2007) suggests that being Shariah approved firm, the debt must be asset- backed and thus, the level of debt of the Shariah-approved firms must not exceed its tangible assets. In addition to that, Obaidullah (2006) advocates that the trade-off theory (TOT) is irrelevant for the Shariah-approved firms due to the element of interest tax shield that is non-existence in Islam. Moreover, if the firm’s objective is to minimize the cost of financing, he further proposes that Shariah approved firm will choose internal equity, debt, Mudarabah-based equity and Musharakah-based equity in that order which is a look-alike a pecking order theory (POT). However, the preference of the financial instruments will not always hold true as it will also depend on the objective function of the firms as well as the constraints that firms face given different sizes and statuses (Ahmed, 2007).
Thus, we may conclude that both conventional and Islamic perspectives, it does not say that people can rely 100% on debt for life survival although it is permitted. It is generally understood and accepted that too much reliance on debt trigger bankruptcy risk and creates a lot more problems thereafter. The impact of having a high debt is not only affected at the individual level but also at the firm level and even worst to the whole economic system. Since, debt creates more problems than solving the problems, as such, we need to have a certain benchmark or guideline in how to determine how much debt firms are supposed to have.
3. CONCEPTUAL FRAMEWORK
The research framework was constructed and developed according to the capital structure theories which are the trade-off theory, the pecking order theory and the agency theory and based on prior studies in the same research area.
In this study, the dependent variable will be proxied by the debt level of the Shariah-approved firms in Malaysia. While, for the explanatory variable, it will be measured by the dummy variable of the year 2020 to capture the impact of the COVID-19 pandemic, which is our main focus in this study. In addition to that, several controlled variables were also included in examining whether the COVID-19 pandemic affect the debt level of Shariah-approved firms in Malaysia. The variables are inclusive of profitability, asset tangibility, growth opportunity, bankruptcy risk, size, gross domestic product (GDP), inflation and the 2008 economic crisis. The selected controlled variables are the common variables that were usually used by the other researchers in the capital structure study.
The conceptual framework of the study can be visualized in below Figure 2.
Figure 2. Conceptual Framework
4. RESEARCH METHODOLOGY 4.1 Sample
The study covers 21 years of analysis from the year 2000 until 2021. The sample of the study is a consistent Shariah-approved firm only during the period of analysis which is around 170 Shariah-approved firms. The Shariah-approved firms may come from various sectors as they traded in Bursa Malaysia. However, financial institutions will be excluded as they pose a different set of rules and guidelines that have been set by the relevant authorities such as Bank Negara Malaysia.
4.2 Empirical model
To examine whether COVID-19 affects the firm’s debt level, the following empirical model was developed.
Yit = β0 + β1COV-19t + β2PROFit + β3TANGit + β4GROWit + + β5SIZEit + β6ZSit + β7INFit + β8GDPt + β9ECOt + εit
4.3 Variables measurement
The above empirical model between the dependent variables and the explanatory variables will be tested using three-panel regression models inclusive of pooled OLS, Random effect model (REM) and Fixed effect model (FEM). The empirical model is also tested for robustness by adjusting the standard error to be clustering at the firm level. Diagnostic tests of the Wald test and the Wooldridge are performed and the models are corrected for heteroskedasticity and autocorrelation problems with robust standard errors.
The details on how the variables are measured can be seen in Table 1 below.
Dependent Variable Shariah approved firm’s debt level Independent Variable
COVID-19 pandemic (Dummy variable)
Controlled Variables
• Profitability,
• Asset Tangibility,
• Growth Opportunity
• Bankruptcy Risk
• Size
• GDP
• Inflation
• 2008 economic crisis
Table 1. Variable Measurement
WHAT TO MEASURE HOW TO MEASURE EXPECTED
RESULT
DEPENDENT VARIABLES (Y)
Debt ratio (DR) Firm’s total debt Firm’s total debt
Firm’s total asset INDEPENDENT VARIABLE (Y)
COVID-19 (COV-19) 2019 COVID-19 Dummy
1= 2020 – COVID-19 0= Other than the year 2019
CONTROLLED VARIABLES (X)
Profitability (PROF) Firm’s net profit margin Firm’s operating income
Firm’s total asset -
Tangibility (TANG) Firm’s asset structure Firm’s fixed asset
Firm’s total asset +
Growth (GROW) Firm’s growth
opportunities
Annual percentage change in total
assets +
Size (SIZE) Firm’s size Log of sales +
Z-score (ZS) Bankruptcy risk
3.3(EBIT/total assets) +
1.0(sales/total assets) + 1.4(retained earnings/total assets) + 1.2(working capital/total assets) + 0.6(MV of equity/total liabilities)
-
Inflation (INF) Annual inflation -
GDP (GDP) GDP growth +
Economic crisis (ECO) 2008 economic crisis Dummy
1= 2008 economic crisis 0= Other than the year 2008
+
5. CONCLUSION
The study aims to investigate whether the COVID-19 pandemic that started in the year 2019 does affect the debt level of Shariah-approved firms in Malaysia. The study is also interested in identifying what are the other factors that may affect the variability of the debt level of Shariah-approved firms in Malaysia. Thus, a conceptual framework has been developed and this study will adopt a panel data regression method. The outcome of the study is expected to provide more valuable information on understanding the financing behaviour of Shariah-approved firms, especially during unforeseen circumstances like the COVID -19 pandemic. Further, since the analysis also includes the 2008 economic crisis variable in form of a dummy variable, the study will be able to identify either the 2008 economic crisis and the 2019 COVID-19 have a different effect or not on the debt level of the Shariah- approved in Malaysia.
Acknowledgment
The authors would like to express appreciation for the support of the sponsor, Universiti Sains Islam Malaysia (USIM) - Grant No: PPPI/FEM/0119/051000/15819.
References
Ahmed, H. 2007. Issues in Islamic corporate finance: Capital structure in firms. Jeddah, Saudi Arabia: Islamic Research and Training Institutes (IRTI).
Donaldson, C. 1961. Corporate debt capacity: A study of corporate debt policy and the determination of corporate debt capacity. Harvard University.
Fama, E. F. 1980. Agency Problem and the Theory of Firm. The Journal of Political Economy 88(2), 288–307.
Fama, E. F., & Miller, M. H. 1972. The theory of finance. Dryden Press.
Frank, M. Z., & Goyal, V. K. 2008. Trade-off and Pecking Order Theories of Debt. In B. E. Eckbo (Ed.), Handbook of corporate finance:
Empirical corporate finance (Vol. 2, pp. 136–202). Amsterdam, The Netherlands: Elsevier.
Huang, H., & Ye, Y. 2021. Rethinking Capital Structure Decision and Corporate Social Responsibility in Response to COVID-19. Accounting and Finance 61(3), 4757–4788. https://doi.org/10.1111/acfi.12740
International Monetary Fund. 2015. Global financial stability report: Vulnerabilities, legacies and policy challenges risks rotating to emerging markets. Washington, DC. Retrieved from http://www.imf.org/en/publications/gfsr/issues/2016/12/31/vulnerabilities-legacies-and- policy-challenges
Jensen, M. C. 1986. Agency Costs of Free Cash Flow, Corporate Finance and Takeovers. American Economic Review 76(1), 323–329.
Jensen, M. C., & Meckling, W. H. 1976. Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure. Journal of Financial Economics 3(4), 305–360.
Leary, M. T., & Roberts, M. R. 2010. The Pecking Order, Debt Capacity and Information Asymmetry. Journal of Financial Economics 95(3), 332–355.
Modigliani, F., & Miller, M. H. 1958. The Cost of Capital, Corporation Finance and the Theory of Investment. The American Economic Review 48(3), 261–297.
Modigliani, F., & Miller, M. H. 1963. Corporate Income Taxes and the Cost of Capital : A Correction. The American Economic Review 53(3), 433–443.
Mohd Azhari, N. K., Mahmud, R., & Sara Naquia Hanim, S. 2022. Capital Structure of Malaysian Companies: Are They Different During the COVID-19 Pandemic? The Journal of Asian Finance, Economics and Business 9(4), 239–250.
https://doi.org/10.13106/jafeb.2022.vol9.no4.0239
Myers, S. C. 1984. The Capital Structure Puzzle. The Journal of Finance 39(3), 575–592.
Myers, S. C., & Majluf, N. S. 1984. Corporate Financing and Investment Decisions when Firms Have Information that Investors Do Not Have.
Journal of Financial Economics 13(1), 187–221.
Obaidullah, M. 2006. Teaching corporate finance from an Islamic perspective. Islamic Economics Research Centre, King Abdulaziz University Jeddah, Kingdom of Saudi Arabia.
The Financial Stability Review - First Half 2020. (2020).
Vasiliou, D., Eriotis, N., & Daskalakis, N. 2009. Testing the Pecking Order Theory: The Importance of Methodology. Qualitative Research in Financial Markets 1(2), 85–96.
Yu, B. 2012. Agency Costs of Stakeholders and Capital Structure: International Evidence. Managerial Finance 38(3), 303–324.
