Impact of Financial Leverage On Sustainable Growth, Market Performance, and Profitability

Economic Change and Restructuring
https://doi.org/10.1007/s10644-021-09321-z
Impact of financial leverage on sustainable growth, market

performance, and profitability
Muhammad Akhtar1 · Kong Yusheng1 · Muhammad Haris1,2 · Qurat Ul Ain3 ·

Hafiz Mustansar Javaid4
Received: 25 December 2019 / Accepted: 21 January 2021

© The Author(s), under exclusive licence to Springer Science+Business Media, LLC, part of Springer Nature
2021
Abstract
The purpose of this study was to measure the impact of financial leverage on the
performance of 424 Pakistani nonfinancial listed companies over the 2001–2017
period. Three measures of financial leverage, i.e., short-term debt (STDL), long-
term debt (LTDL), and total debt (TLEVR), were applied to examine their impact
on performance, i.e., sustainable growth (SGR), Tobin’s Q, return on assets (ROA),
return on equity (ROE), and return on sales (ROS). Robust results obtained using
the generalized method of moments (GMM) report a significant negative impact of
financial leverage on performance. The results also confirm an inverted U-shaped
relationship between financial leverage and performance, indicating that an increase
in the financial leverage of Pakistani listed companies increases their performance
up to a certain level, and after that, a further increase in financial leverage decreases
their performance. The results further suggest that STDL is a main contributing
source of debt that causes a higher risk of refinancing for companies and thus nega-
tively affects performance. This study’s findings are useful for academics, manage-
ment, policymakers, and regulators to understand the importance of financial lever-
age and to choose between STDL and LTDL to fund financial needs.
Keywords Financial leverage · SGR · Tobin’s Q · ROA · ROE · ROS · GMM ·

Pakistan
JEL Classification C23 · G32 · G33 · L25
* Muhammad Akhtar
[email protected]
1
School of Finance and Economics, Jiangsu University, 301 Xuefu Road, Zhenjiang 212013,
Jiangsu Province, China
2
Department of Business Administration, NFC Institute of Engineering and Technology, Multan,
Pakistan
3
School of Economics and Finance, Xi’an Jiaotong University, Xi’an 710049, China
4
School of Economics, Sapienza Università Di Roma, 00161 Roma, Italy
13
Vol.:(0123456789)
1 Introduction
The understanding of financial leverage assists companies in assessing their finan-

cial needs, borrowing capacity and ability to generate returns to maximize perfor-
mance. Therefore, the understanding of financial leverage is important not only
for firms to assess their borrowing and financial needs but also for policymakers
to extend the strategic directions with regard to the capital structure. Theoretically,
it indicates that higher leverage leads to higher agency costs, and thus, a more-
leveraged firm needs to be focused more on enhancing its financial performance to
cater to agency problems. Hence, some studies have suggested that the relationship
between firm performance and financial leverage can be negative because of higher
finance costs (Barry and Mihov 2015; Dawar 2014; Harris and Raviv 1991; Majum-
dar and Chhibber 1999; Ramli et al. 2019; Zhang and Chen 2017). However, it is
also argued that a firm with higher debt financing places a burden on managers to
maximize its performance; therefore, some studies argue that a positive association
exists between financial leverage and firm performance (Detthamrong et al. 2017;
Ross 1977; Vithessonthi and Tongurai 2015). Additionally, some studies have found
that financial leverage has both positive and negative relationships with firm perfor-
mance and reported a nonlinear (an inverted U-shaped) relationship between perfor-
mance and financial leverage (Bae et al. 2017; Dalci 2018; Davydov 2016; Le and
Phan 2017). In this regard, they argued that high financial leverage reduces agency
problems and increases profitability by enabling managers to increase tax shields
and to use resources more efficiently (Jensen 1986; Modigliani and Miller 1963;
Scott Jr 1977; Williams 1987). However, they also argued that this positive relation-
ship exists up to a certain level, and after that, a further increase in financial leverage
reduces performance (Dalci 2018; Le and Phan 2017).
Over the past six decades, financial leverage has been of continuing interest
among several researchers to examine the association between financial leverage
and firm performance. It is believed that during the formulation process of capital
structure, a firm should ensure an optimal arrangement of equity and debt, which
is essential for enhancing the firm’s performance (Ahmed and Afzal 2019). Since
the pivotal work on debt was done by Modigliani and Miller (1958), debt has been
studied by many researchers to see how the volume of debt can affect the capital
structure of a firm because debt is used as an alternate means to finance financial
needs (Kraus and Litzenberger 1973; Myers and Majluf 1984). Furthermore, Kraus
and Litzenberger (1973) argued that a higher level of debt can shield earnings from
corporate income taxes; therefore, debt is beneficial. They also argued that as the
level of debt increases, it may lead firms to the danger of bankruptcy by increasing
the marginal cost and declining the marginal benefit of debt. Therefore, when choos-
ing how much debt and equity to use for financing its needs, a firm will focus on the
trade-off between debt and equity to optimize its value (Murray Z 2008). Therefore,
an inverted U-shaped relationship between performance and financial leverage can
be yielded due to the conflict between the cost and benefit of debt.
Although several studies on the relationship between financial leverage and firm
performance have been conducted in other countries, there are few in-depth studies
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in emerging countries such as Pakistan. The current study is different from previ-
ous studies in many aspects. First, it employs cross-sectional panel regressions to
empirically analyze the effect of short-term debt (STDL), long-term debt (LTDL),
and total debt (TLEVR) on firm performance instead of concentrating on the instant
reaction of the stock market to financial leverage arrangements and examines the
continuous effect of STDL, LTDL, and TLEVR choices on firm performance. The
potential market over- (under) reaction to the placement of financial leverage can
be eliminated by using this approach. Second, the analysis uses exact ratios of three
measures of financial leverage in the capital structure of firms instead of dummy
variables. These ratios in the relationship between the levels of financial leverage
and firm performance allow us to account for potential nonlinearity. Third, in this
study, the generalized method of moments (GMM) methodology developed by Arel-
lano and Bond (1991) is adopted, which can take into account the nonlinear associa-
tion between financial leverage and firm performance because robust fixed effects
(FE) and random effects (RE) methods are also used. However, biased and inconsist-
ent results are generated with the use of linear regressions and OLS regressions (FE
and RE) due to the presence of endogeneity, unobserved heterogeneity, and serial
correlation (Baltagi 2001). Moreover, using financial leverage to assess the influ-
ence of financial leverage choices on firm performance due to endogeneity problems
may lead to faulty conclusions. Therefore, the issues of potential reverse causality
are addressed using advanced instrumental variable techniques, i.e., GMM. Hence,
the instruments used in this study are novel and have never been used in previous
studies. The validity of the instrumental variables is further discussed in Sect. 3.2.2.
Subsequently, the use of GMM in this study addresses problems related to endoge-
neity, serial correlation, unobserved heterogeneity, and performance persistence and
produces robust and consistent results.
Fourth, the current study uses data on firms that have access to financial lever-
age, divided into three measures (STDL, LTDL, and TLEVR), which create more
homogeneous determinants of financial leverage source choices. Therefore, the find-
ings of the study should not be affected by firm-specific factors that determine the
choices among STDL, LTDL, and TLEVR. Fifth, instead of concentrating on a spe-
cific period and short sample, the estimations of this study are conducted on a data-
set for 424 Pakistani nonfinancial listed firms for a long period (2001–2017), which
includes the period of the recent global crisis (2008). Hence, this approach allows us
to capture any changes in the effect of financial leverage source composition on firm
performance during periods of financial distress and during normal times. Sixth, the
use of long-term debt (LTDL) is minimal, at 17.8%, while short-term debt (STDL)
is most used, at 49.9%. This indicates that for Pakistani, nonfinancial listed firms
mainly rely on STDL. This is also a main factor that differentiates the financial lev-
erage of Pakistani firms from that of other firms in developed countries. Seventh,
both models of SGR (Higgins and Van Horne’s static models), market-based per-
formance (Tobin’s Q), accounting-based performance (ROA, ROE and ROS), along
with independent variables, i.e., financial leverage (STDL, LTDL, and TLEVR),
and control variables, i.e., company-specific variables (firm size, risk, liquidity, age,
nondebt tax shield, government ownership, and foreign ownership) and macroeco-
nomic variables (gross domestic product, inflation, and foreign direct investment),
13
are not used in any other study, which makes our study novel and unique from previ-
ous studies. To the best of our knowledge, such a study has never been conducted
before.
Furthermore, the contribution of this study helps to understand how and to what
extent financial leverage supports economic activities and the sustainable growth of
Pakistani nonfinancial listed companies in the setting of Pakistan’s transition econ-
omy. Specifically, our study has two meaningful aspects. First, the current study
shows alternative financing mechanisms and features provided by financial leverage
in the Pakistani context, and few studies have directly studied whether financial lev-
erage can promote the sustainable growth of firms. Our research supplements earlier
studies of financial leverage policies and delivers the first proof of their importance
in the sustainable growth of firms. Second, regarding the external institutional envi-
ronment and internal characteristics of enterprises, we test whether there are dif-
ferences in how they promote firm sustainability depending on the use of financial
leverage (Huang et al. 2019).
The rest of the study is structured as follows. The theoretical framework, litera-
ture review, and hypothesis are discussed in Sect. 3. Section 4 discusses the data
and research methodology. The results of the study are outlined in Sect. 5. Finally,
Sect. 6 presents the conclusion and implications.
2 Overview of firms in Pakistan
The structure of firms listed on the Pakistan Stock Exchange (PSX) is based on
financial and nonfinancial factors. The State Bank of Pakistan (SBP), as the only
central bank, categorizes financial firms into 11 sectors and nonfinancial firms
into fourteen sectors. The financial sectors include banking, microfinance banking,
investment banking, leasing, modarba, insurance, exchange, mutual funds, develop-
ment finance, housing finance, and venture capital. The nonfinancial sectors include
textiles, chemicals and pharmaceuticals, manufacturing, sugar, motor vehicle and
auto parts, cement, food products, fuel and energy, information communication and
transport, coke and refined petroleum products, paper paperboard and products, min-
eral products, electrical machinery and apparatus, and other services activities. The
ownership structures of these firms are public (i.e., government-owned), private and
foreign-owned. The performance of the 424 nonfinancial firms included in our sam-
ple over the last decade (2007–2017) indicates that total assets increased to 7124 bil-
lion rupees from 2360 billion rupees, total equity increased to 2856 billion rupees
from 1007 billion rupees, the short-term leverage ratio decreased to 41.18% from
43.18%, the long-term leverage ratio increased to 18.72% from 14.12%, and the total
leverage ratio increased to 59.90% from 57.31%. As for financial performance, over
the last decade (2007–2017), SGR decreased to 25.27% from 54.38%, Tobin’s Q
increased to 2.19 from 1.38, ROA decreased to 6.19% from 7.02%, ROE decreased
to 25.76% from 30.87%, and ROS increased to 11.72% from 10.47%. Thus, it is very
relevant to examine the contribution of financial leverage to financial performance.
In addition, the capitalization of the PSX in 2007 was 3980.8 billion rupees, which
increased to 9594.8 billion rupees in 2017. The GDP of Pakistan increased from
13
5553 billion rupees in 2007 to 12,417 billion rupees in 2017 (http://finance.gov.pk/),

indicating a huge increase in GDP that offered opportunities for Pakistani firms to
grow and increase their earnings.
Furthermore, the Pakistani nonfinancial sector has made an extensive contribu-
tion over the years to the gross domestic product (GDP) of the country. The Paki-
stani nonfinancial sector is broadly based on the industrial and service sectors. These
sectors are very important because both contribute a large share of Pakistan’s GDP.
According to the Economic Survey of Pakistan, in the last decade (2007–2017), the
GDP share of the industrial sector decreased to 20.88% in 2017 from 21.4% (2007),
and the GDP share of the service sector increased to 56.22% in 2017 from 52.3%
(2007). If we combine the share of both sectors, it increased to 77.1% in 2017 from
73.7% (2007), which describes the higher importance of nonfinancial sectors for
the economic growth of the country. However, comparatively, the financial sector
of Pakistan contributed only 3.37% of GDP in 2017 and 3.8% in 2007 (http://finan
ce.gov.pk/). Therefore, our study is of great importance to obtain insight into the
favorable and unfavorable factors of the performance of Pakistani nonfinancial listed
companies. Controlling and/or boosting these factors will enhance firms’ perfor-
mance and allow them to continue their positive role in the economic growth of the
country and vice versa.
3 Literature review
3.1 Theoretical context
As stated, most capital structure theories agree that in an imperfect market, financial
leverage can affect a firm’s performance in several ways. Several theories explain
the relationship between firm performance and capital structure. The theory that is
considered a foundation theory is Modigliani–Miller (MM) theory, as per this the-
ory, firm value or performance is not influenced by its capital structure (Modigliani
and Miller 1958). However, MM theory is based on a concept that does not exist in
the real world: the restrictive assumption of a perfect capital market. The three main
alternative theories to MM theory that account for an imperfect market are trade-off
theory, pecking order theory, and agency theory. According to these theories of cap-
ital structure, performance or profitability is influenced by the tax effect, financial
distress, information asymmetry, agency costs, and bankruptcy costs (Modigliani
and Miller 1963; Myers and Majluf 1984; Scott Jr 1977). Trade-off theory explains
that interest paid on financial debt is tax deductible; thus, a firm can enhance its prof-
itability through external debt (Modigliani and Miller 1963). A firm can decrease its
tax obligations by paying interest, which reduces income; hence, the increase in debt
comes from the tax shield (Modigliani and Miller 1963). This theory also states that
interest payments lead firms toward bankruptcy, financial distress, and default risk
(Modigliani and Miller 1963). Therefore, by increasing financial risk, the cost of
debt mainly derives from direct and indirect bankruptcy costs (Kim 1978; Kraus and
Litzenberger 1973). In short, after deducting the cost of financial distress, the value
of a firm with debt is identical to the value of a firm without debt plus the tax shield.
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The pecking order theory states that financing follows hierarchy (Myers and
Majluf 1984). Internal financing is used first, then debt is used and equity is issued
only when no more debt can be obtained; therefore, according to this theory, firms
first prefer internal to external (i.e., debt) financing and then debt to equity financ-
ing (Le and Phan 2017; Myers and Majluf 1984). As per pecking order theory, three
types of costs, i.e., issuing costs, transaction costs, and asymmetric information, are
associated with financing. Internal financing, i.e., retained earnings, involves fewer
issuing costs and transaction costs than other external sources. Thus, retained earn-
ings are preferred to external funds. Compared to debt with equity, debt obtains
lower information costs. This theory also argues that external investors possess
less information about firms than their managers do. Therefore, external investors
demand a higher return on their equity investments, and thus, debt is preferred to
equity. However, there is no limit to the specification of debt volume argued by this
theory. The rising demand for external financing determines a change in the volume
of debt when internal funds are completely utilized (Dalci 2018; Le and Phan 2017).
The agency cost theory regarding the relationship between firm performance and
financial leverage suggests conflicting predictions (Dalci 2018; Jensen 1986; Kent
Baker et al. 2007; Williams 1987). These conflicts arise among shareholders, man-
agers, and creditors, i.e., debt holders. The conflict among shareholders and manag-
ers raises the agency cost of equity because during the flow of higher equity, man-
agers seek to attain their personal rather than shareholder objectives by investing
equity in unviable projects (Jensen and Meckling 1976). However, acquiring higher
debt, on the one hand, forces managers to seek profitable avenues for generating
higher cash flows to make interest and debt repayments and thus positively affects
performance (Dalci 2018; Jensen 1986; Stulz 1990). Williams (1987) found that in
the case of highly leveraged firms, an act of inspiring managers to act more in the
interests of equity holders helps reduce agency costs, which increases firm perfor-
mance. On the other hand, when debt is higher, shareholders seek suboptimal invest-
ments, while debt holders expect higher returns because of the risk associated with
their holdings; thus, in this way, debt leads to another conflict between shareholders
and debt holders (Myers 1977). Consequently, a higher volume of debt enhances the
agency cost of debt and negatively affects performance (Harris and Raviv 1991; Le
and Phan 2017). In summary, consistent with these theories, financial leverage may
have a significant association with firm performance.
3.2 Empirical evidence
3.2.1 Firms from Pakistan
Recently, using OLS regression, Ahmed and Afzal (2019) found a negative
relationship between performance and financial leverage (i.e., short-term debt,
long-term, and total debt ratios) and a positive relationship between perfor-
mance (ROA, ROE, and Tobin’s Q) and size, liquidity, risk, and firm age for 396
Pakistani nonfinancial companies for the 2006–2013 period. A study by Ahmed
Sheikh and Wang (2013) using OLS regression, fixed effects, and random effects
13
found a negative impact of all measures of financial leverage (i.e., short-term

debt, long-term, and total debt ratios) and a positive impact of size on the per-
formance (ROA) of 240 Pakistani nonfinancial companies for a period of 6 years
(2004–2009). A study by Shahzad et al. (2015) used pooled OLS, FE, and RE
panel estimation models and found a negative relationship between performance
(ROA) and financial leverage (i.e., short-term debt, long-term debt, and total debt
ratio) and size. However, their study found a positive relationship between short-
term debt and Tobin’s Q of 112 textile companies listed on the Pakistani Stock
Exchange for the 1999–2012 period. Previously, Akhtar et al. (2012) used fixed
effects and random effects methods and found a positive relationship between
financial leverage (total debt) and the performance of 20 Pakistani listed compa-
nies from the fuel and energy sector for the 2000–2005 period. Another study by
Samo Asif and Murad (2019) using a quantitative approach, pooled panel regres-
sion, and a descriptive statistics model found a negative relationship between
financial leverage (total debt) and profitability. They found a positive relationship
between liquidity and profitability (ROA and ROE) for 40 textile companies in
Pakistan for the 2006–2016 period.
3.2.2 Negative impact of financial leverage on firm performance
In the long run, firms underperform with higher debt, as revealed by Barry and
Mihov (2015). A high debt ratio decreases firm performance because miscalculat-
ing the bankruptcy costs of liquidation or reorganization may lead firms to have
higher debt than they should; as a result, the agency cost of debt increases (Har-
ris and Raviv 1991). Previously, Majumdar and Chhibber (1999), using a linear
regression, found a negative relationship between profitability and financial lever-
age (short-term debt and long-term debt) and firm age. Furthermore, their study
found a positive relationship between profitability and size and liquidity for 1000
Indian firms over the 1988–1994 period. A study by Zhang and Chen (2017) used
the GMM methodology and analyzed the relationship among financial leverage
(i.e., short-term debt, long-term debt, and total debt) and the performance of 65
Chinese listed firms over the 2007–2016 period. Their study found a negative
relationship between financial leverage and ROA. However, they found a positive
relationship between NDTS and ROA and a negative relationship between NDTS
and SGR. A recent study by Ramli et al. (2019) using the PLS-SEM method
found a negative association between financial leverage (i.e., short-term debt,
long-term debt, and total debt) and the performance of Indonesian firms over the
1990–2010 period. Another study by Zeitun and Tian (2014) applied the random
effects method and found a negative relationship between five financial leverage
indicators (i.e., short-term debt, long-term debt, total debt ratios, total debt to
total equity, and total debt to total capital) and performance (ROA and Tobin’s
Q). They also found a positive relationship between size and the performance of
167 Jordanian firms for the 1989–2003 period.
13
3.2.3 Positive impact of financial leverage on firm performance
Higher debt issuance may lead to a higher probability of insolvency, and a firm with
better prospects will issue more debt than a firm with worse prospects, as stated by
Ross (1977). Therefore, a higher debt level increases firm value because it devel-
ops a positive market perception about the firm’s situation. Similarly, Vithessonthi
and Tongurai (2015) demonstrated that SMEs that achieve improved financial per-
formance using a higher level of leverage always prefer debt financing (total debt).
Therefore, their study found a positive relationship among debt financing, GDP and
size but found a negative relationship between firm age and the performance of Thai
firms over the 2007–2009 period. A study by Abor (2005) applied OLS regression
to data of 22 Ghanaian firms for the 1998–2002 period and found that short-term
debt, long-term debt, and firm size are positively associated with ROE. Detthamrong
et al. (2017) applied a quantitative approach to analyze the relationship between
the performance and financial leverage (total debt) of 493 Thai nonfinancial firms
for the 2001–2014 period. Their study found that financial leverage has a positive
relationship with firm performance. However, firm size and firm age have a nega-
tive relationship with firm performance. Ramli et al. (2019), using the PLS-SEM
method, found a positive relationship between financial leverage (i.e., short-term
debt ratio, long-term debt, and total debt) and the performance of Malaysian firms
over the 1990–2010 period.
3.2.4 Nonlinear relationship between financial leverage and firm performance
Additionally, some studies have found that financial leverage has positive and nega-
tive effects on firm performance and affirmed a nonlinear relationship, i.e., inverted
U-shaped association, among firm performance and financial leverage. Previously,
both positive and negative effects on firm performance were found in a model devel-
oped by Stulz (1990). A study by Le and Phan (2017), using the GMM method,
found that there exists an inverted U-shaped relationship between financial lever-
age (i.e., short-term debt and total debt) and firm performance (ROE). Additionally,
their study found a negative relationship between performance and risk and a posi-
tive relationship between performance and liquidity for Vietnamese listed compa-
nies for the 2007–2012 period. Furthermore, a study by Dalci (2018) using GMM
analyzed the relationship between the performance and financial leverage of 1503
Chinese listed manufacturing firms for the 2008–2016 period and found a nonlinear
relationship between financial leverage (i.e., short-term debt and total debt) and firm
performance (ROA and ROE). Additionally, their study found a negative relation-
ship between GDP and firm size and a positive relationship between inflation and
firm performance. Earlier, Jaisinghani and Kanjilal (2017), using a panel threshold
regression methodology, found nonlinear relationships between long-term debt and
profitability. Additionally, their study found a negative relationship between size
and the profitability of 1194 Indian manufacturing firms for the 2005–2014 period.
Furthermore, Margaritis and Psillaki (2010), using nonparametric data envelopment
analysis (DEA), analyzed the relationship between financial leverage (long-term
debt) and the performance of French manufacturing firms for the 2002–2005 period
13
and found a reverse causal relationship. Similarly, Lin and Chang (2011), employ-
ing an advanced panel threshold regression model, found that there are two thresh-
old effects between financial leverage (total debt) and firm performance (Tobin’s
Q). Additionally, their study found that size and age are negatively associated,
while risk is positively associated with the Tobin’s Q of 196 Taiwanese firms for
a period of thirteen years (1993–2005). Finally, Bae et al. (2017) found an inverted
U-shaped association between performance and financial leverage (long-term book
leverage) and a negative association between performance and size and firm age for
1481 American firms for the years 1970–2011. In particular, debt payments force
managers to generate cash flows by reducing overinvestment problems, and hence,
higher leverage has a positive impact on performance. In contrast, higher leverage
may exhaust cash flow, which reduces the funds available for profitable investment
and thus exacerbates underinvestment problems and negatively affects performance.
Therefore, the literature has two leverage-profitability relationships.
3.3 Hypothesis development
Little research has been conducted on emerging and transition economies and pro-
vides mixed and contradictory results regarding the linkage between financial lever-
age and firm performance. Additionally, relating to the capital structure, most stud-
ies on developed countries posit a positive relationship between financial leverage
and firm performance, while some studies investigating this relationship for emerg-
ing markets have found a negative relationship between financial leverage and firm
performance. Specifically, the studies of Margaritis and Psillaki (2010), Berger and
Bonaccorsi di Patti (2006), and Gill et al. (2011) argued that the use of more finan-
cial leverage reduces agency costs of equity by encouraging managers to act more
in the interests of shareholders and found that a higher financial leverage ratio is
associated with higher firm performance. However, the studies of Zeitun and Tian
(2014), Majumdar and Chhibber (1999) and Abor (2007) with regard to Ghana, Jor-
dan, India, and South Africa found a negative impact of financial leverage on firm
performance. As per their arguments, underestimating the bankruptcy costs of liqui-
dation may lead firms to have more financial leverage than they should, and thus, a
high financial leverage ratio decreases firm performance. Furthermore, in emerging
markets, as a monitoring channel to improve firm performance, the role of finan-
cial leverage is not considerable. Thus, large cash flows from financial leverage can
lead managers to undertake discretionary behavior and negatively affect firm perfor-
mance. Using Pakistan as a typical emerging market, the first hypothesis with regard
to the relationship between financial leverage and performance is hypothesized as
follows:
H1 There is a significant relationship between financial leverage and the perfor-

mance of Pakistani listed companies.
Financial leverage can have both positive and negative effects on firm performance;
consequently, a number of current studies have also found a nonlinear relationship
13
between financial leverage and firm performance in other economies. Specifically,

at a low level, by reducing the agency costs of equity, financial leverage can increase
firm performance. However, when financial leverage is sufficiently high, the benefits
of financial leverage are overcome by the costs of financial leverage, including agency
costs of debt and financial distress, as an increase in financial leverage can decrease
firm performance (Jensen 1986; Kraus and Litzenberger 1973; Le and Phan 2017;
Myers and Ma 1984). Therefore, this study also allowed for the presence of positive
and negative effects of financial leverage levels on firm performance using a quad-
ratic function, as used by Margaritis and Psillaki (2010), Dalci (2018), and Berger and
Bonaccorsi di Patti (2006). Thus, the second hypothesis of this study is as follows:
H2 There is a nonlinear (inverted U-shaped) relationship between financial leverage

and the performance of Pakistani listed companies.
4 Data and methodology
4.1 Sample and data
As of the end of 2017, a total of 560 companies (both financial and nonfinancial) were
listed on the Pakistan Stock Exchange. Due to the unique nature of financial state-
ments of financial institutions such as banks, insurance companies, and other financial
intermediaries, these were omitted from the sample (Al‐Najjar 2011; Pandey 2001).
The sample for this research consists of unbalanced panel data for 424 nonfinancial
companies listed on the Pakistan Stock Exchange Limited (PSX) and operating during
the period of seventeen years from 2001 to 2017, generating a total of 6085 firm-year
observations. The samples of this study are based on nonfinancial listed companies that
are categorized into fourteen sectors by the State Bank of Pakistan (SBP). The detailed
list of samples is presented in Table 1. Data on the dependent variables (SGR, Tobin’s
Q, ROA, ROE, and ROS) and company-specific variables (firm size, risk, liquidity,
firm age, and nondebt tax shield) were obtained from audited annual financial state-
ments. The statements were obtained from the State Bank of Pakistan (http://www.sbp.
org.pk) and each respective company. The data on the macroeconomic variables (gross
domestic product (GDP), foreign direct investment (FDI), and inflation (INF)) were
obtained from the World Bank database.
To ensure the reliability of the data and to minimize measurement errors, firms
with less than five years of data were excluded from the sample. Hence, we used a
large number of companies (424) as a sample with a longer time period (2001–2017).
STATA 15 was used to analyze our data to test the developed hypotheses.
13
Table 1 List of samples

Sr. No Industry Sample companies Observations
1 Textile 161 2295

2 Chemicals and pharmaceuticals 47 688
3 Manufacturing 35 502
4 Sugar 34 543
5 Motor vehicle and auto parts 25 355
6 Cement 24 340
7 Food products 20 278
8 Fuel and energy 19 273
9 Information, comm. and transport 13 175
10 Coke and refined petroleum products 11 151
11 Paper, paperboard and products 10 125
12 Other services activities 10 125
13 Mineral products 08 124
14 Electrical machinery and apparatus 07 111
Total 424 6085
4.2 Methodology
4.2.1 Variables
This study uses five main measures of firm performance, i.e., SGR, Tobin’s Q, ROA,
ROE, and ROS, of nonfinancial companies listed on the PSX. Higgins (1977) sug-
gested that the growth of a firm’s sales without borrowing more money and sell-
ing new equity is the actual meaning of the SGR. Most firms aim to reach certain
objectives to be successful in the future. The SGR is an objective that companies
aim to reach in order to survive and remain attractive to their investors, analysts,
and bankers. It combines companies’ financial (capital structure and retention ratio)
and operating (asset efficiency and profit margin ratio) elements into a single meas-
ure; therefore, SGR is seen as valuable. Using the SGR, based on current perfor-
mance, policymakers, investors, and managers can gauge whether a firm’s growth
plans are realistic, thus providing them with an understanding of the levels of cor-
porate growth. The sustainable growth model is mostly used to evaluate the over-
all management of its operations and to assist in direction-finding a company so
that its financial resources and its sales growth are compatible (Chang 2012). The
SGR measures the lasting competitiveness and long-term profitability of enterprises
(Huang et al. 2019). To calculate the sustainable growth rate, we used the Higgins
model (Higgins 1977; Huang et al. 2019). According to Van Horne, the SGR of
enterprises is the largest annual growth percentage of enterprise sales under a cer-
tain operating and debt-to-dividend ratio, emphasizing that the SGR is the target
value rather than the actual value (McMillan and Woodruff 1999). In a robustness
test in this study, referring to prior studies by Demirgüç-Kunt and Maksimovic
(1998) and Huang et al. (2019), we also used Van Horne’s static model of the SGR,
13
which was denoted by SGR1. Only those companies can expand their companies’
sales and assets that maintain their capital structure and do not sell new equity (Platt
et al. 1995). Hence, the sustainable growth rate is closely related to the performance
and success of a company.
As the SGR is widely used to plan sustainable growth, borrowing strategies, cash
flow projections and capital acquisitions in the long run; therefore, the SGR is the
first indicator used in this study to measure long-term sustainable performance. Fol-
lowing Higgins (1977) and Xu and Wang (2018), SGR is calculated as (P*A*T*R),
where P is the net profit ratio measured as profit after tax divided by net sales, A is
the asset turnover ratio measured as net sales divided by total assets, T is equity mul-
tiplier measured as total assets divided by total equity, and R is retention ratio meas-
ured as retained earnings divided by net profit. Tobin’s Q is the second indicator
used to measure the market-based performance of firms. Following Driffield et al.
(2007) and Le and Phan (2017), Tobin’s Q was calculated as the book value of total
debt and the market value of equity divided by the book value of total assets. ROA,
ROE, and ROS are used to measure the accounting-based performance of firms; the
corresponding values were obtained from previous studies (Dalci 2018; Jiraporn
and Liu 2008). ROA was calculated as net income divided by average total assets
and reflects the efficient utilization of assets. ROE was measured by earnings before
interest and tax to average equity, and it reflects how efficiently a firm uses money
invested by the shareholders to generate value for them. ROS was calculated as earn-
ings before interest and tax to sales and indicates a firm’s efficiency in achieving
optimum sales while simultaneously minimizing costs (Brealey 2001).
The main independent variable used in this study is financial leverage, which is
divided into three measures, i.e., short-term debt (STDL), long-term debt (LTDL),
and total debt (TLEVR). If financial leverage is measured only using TLEVR (total
liabilities divided by total assets), it may ignore the relationships between STDL
and LTDL and performance because total liabilities are based on the summation
of short-term and long-term liabilities (Twairesh 2014). Therefore, to obtain more
robust results and offer better policy implications, our study followed Zhang and
Chen (2017), Bae et al. (2017), and Dawar (2014) and further divided the total debt
ratio into the STDL ratio (short-term liabilities divided by total assets) and LTDL
ratio (long-term liabilities to total assets).
Further, to minimize the specification bias in the models, our study followed
Dawar (2014), Vithessonthi and Tongurai (2015), Davydov (2016), Le and Phan
(2017), Zhang and Chen (2017), Dalci (2018), and Danso (2019) to account for
the impact of company-specific variables (firm size (FSIZE), risk (Risk), liquidity
(LIQ), firm age (FAGE), nondebt tax shield (NDTS), government-owned (GOWN)
and foreign-owned (FOWN)) and macroeconomic variables (GDP, foreign direct
investment (FDI), and inflation (INF)) on firm performance. FSIZE was measured
as the natural logarithm of total assets. The size of a firm may influence company
performance due to differences in the operating environment, diversification of
business, access to the market and information asymmetry (Ferri and Jones 1979;
Myers and Majluf 1984; Sadeghian et al. 2012; Vithessonthi and Tongurai 2015).
Risk was measured through Altman’s Z-score model, which is often used to meas-
ure the degree of financial distress (Altman 1983). Altman’s Z-score is measured as
13
1.2*(working capital/total assets) + 1.4*(retained earnings/total assets) + 3.3*(earn-

ings before interest and taxes/total assets) + 0.6*(book value of equity/book value
of total liabilities) + 0.999*(sales/total assets). Recently, Altman et al. (2017) found
that using Altman’s Z-score model to measure risk still yields satisfactory results.
LIQ is calculated as the current assets divided by current liabilities. FAGE is cal-
culated as the natural logarithm of the total number of years since the firm’s incep-
tion. NDTS is measured as the ratio between depreciation expenses and total assets.
The two dummy variables, i.e., GOWN and FOWN, were used to account for the
ownership effect. To control for the effect of government ownership, a value of 1
was assigned to firms with majority shareholding held by the government of Paki-
stan and 0 otherwise. To control the effect of foreign ownership, a value of 1 was
assigned to firms with the presence of at least one foreign director on the board and
0 otherwise. Among macroeconomic variables, the natural logarithm of GDP was
used as a proxy to control the effect of economic growth. The natural logarithm of
FDI inflows as a percentage of GDP was used to examine the impact of economic
development. The natural logarithm of the annual inflation rate was used to examine
the impact of the INF on firm performance. Furthermore, the details of the variables
used in the current study are given in Table 2.
4.2.2 Analysis approach and methodology
However, the problems of possible heteroskedasticity and autocorrelation can be

resolved by using ordinary least squares (OLS), fixed effects (FE), and random
effects (RE) regressions with standard errors. However, for empirical research,
endogeneity problems still exist due to reverse causality, measurement errors, time
invariance, and endogenous variables (Wintoki et al. 2012). For example, firms
with higher profitability retain higher equity and lower leverage and vice versa (Yao
et al. 2018, 2019). Similarly, the performance of firms may persist over time, which
means that the previous year’s performance affects the next year’s performance
(Smriti 2018). Furthermore, unobserved heterogeneity is another major problem for
empirical researchers, e.g., the performance of firms might be affected by the differ-
ence in the attitudes of managers toward internal and external policies. Therefore,
in the presence of endogeneity, performance persistence, and unobserved heteroge-
neity, the use of OLS, RE, and FE sometimes gives biased and inconsistent results
(Baltagi 2001). Hence, to offer unbiased and consistent results, the two-step system
GMM estimator developed by Arellano and Bover (1995) and Blundell and Bond
(1998) was used in this study. It deals with four main problems, i.e., unobserved het-
erogeneity, endogeneity, persistent performance, and serial correlation. For robust-
ness, the FE and RE methods were also used in this study.
GMM allows the use of the lagged dependent variable along with the lagged endog-
enous variables in both levels and differences. It also allows instrumenting the strictly
exogenous variables in both levels and differences. This study followed Dalci (2018),
Le and Phan (2017), and Haris et al. (2019) to address endogeneity. It used all financial
leverage measures as endogenous variables and instrumented them using a two-year
lag, along with the lag of performance indicators. Additionally, the strictly exogenous
variables are instrumented in levels. Since GMM allows the use of instruments, Yao
13
Table 2 List of variables
Variable Notation Description Expected results
13
Dependent
Sustainable growth rate SGR Net profit ratio × Asset turnover ratio × Retention rate × Equity multiplier
Tobin’s Q Tobin Q Book value of total debts and market value
of equity divided by book value of total asset
Return on asset ROA Net income to average total asset
of equity divided by book value of total asset
Return on equity ROE Earnings before interest and tax to average equity
Return on sale ROS Earnings before interest and tax to sales
Independent
Short-term debt STDL Short-term liabilities by total assets −
Long-term debt LTDL Long-term liabilities by total assets −
Leverage TLEVR Ratio of the total debt-to-total assets −
Company-specific variables
Firm size FSIZE Logarithm of total assets −
Risk Risk Altman’s Z-score +
Liquidity LIQ Current assets by current liabilities −
Firm age FAGE Natural logarithm of the number of years of a firm since its inception +/−
Nondebt tax shield NDTS Depreciation expenses by total assets −
Government-owned GOWN Equals to 1 if a company is owned and managed by Government, and 0 otherwise +
Foreign-owned FOWN Equals to 1 if a company represents at least one foreign director on its board, and 0 +
otherwise
Macroeconomic
Economic growth GDP Natural logarithm of GDP +
Foreign direct investment FDI Natural logarithm foreign direct investment inflows as percentage of GDP +
Inflation INF Natural logarithm of annual inflation rate −
et al. (2018) observed that the validity of these instruments is crucial for the consist-
ency of GMM performance. Therefore, the GMM, under the null of joint validity of
the instruments, calculates Hansen J-statistics of the overidentifying restrictions (Yao
et al. 2019). Hansen J-statistics indicate the validity of the instruments used. The GMM
also addressed the first-order autocorrelation AR(1) and second-order autocorrelation
AR(2) under the null of no serial correlations (Arellano and Bond 1991). However,
the validity of GMM is determined with the absence of AR(2), even in the presence of
AR(1). The use of orthogonal deviation in GMM reduces the gap in the transformed
data and subtracts the average of future available observations of a variable, while the
first-difference transformations magnify the gap; therefore, this study applied orthogo-
nal deviation (Arellano and Bover 1995; Yao et al. 2019). Furthermore, Windmeijer
(2005) introduced corrections to the standard errors to reduce the bias in the estimated
asymptotic standard errors when using a small sample. Although the sample of this
study is not small, to avoid any potential bias, we applied Windmeijer’s (2005) correc-
tions to offer more robust and correct inferences.
4.2.3 Econometric specification
This study applied a two-step system GMM estimator on unbalanced dynamic panel
data for 424 nonfinancial Pakistani companies listed on the PSX for the 2001–2017
period and for robustness fixed effects (FE) and random effects (RE) methods. The
GMM estimator was used to analyze the impact of financial leverage on the perfor-
mance of Pakistani nonfinancial listed companies. For this purpose, the following
econometric equations were developed. Equation (1) measures the impact of STDL on
firm performance. Equation (2) measures the impact of LTDL on performance. Equa-
tion (3) measures the impact of TLEVR on performance. Furthermore, this study also
proposes to determine the presence of an inverted U-shaped association between finan-
cial leverage and performance using the squared value of each measure of financial
leverage (STDL2, LTDL2 and T LEVR2). Therefore, following Le and Phan (2017) and
Dalci (2018), Eq. (4) measures an inverted U-shaped relationship between firm perfor-
mance and STDL. Equation (5) measures an inverted U-shaped association between
LTDL and performance. Equation (6) measures an inverted U-shaped association
between TLEVR and the performance of Pakistani listed companies. Furthermore,
adding a one-year lag of the dependent variables as an independent variable to the left
side in each econometric equation makes this study’s model dynamic. The econometric
equations used in this study are given as follows.
K L
∑ ∑
Pit = 𝛼0 + 𝛿Pit−1 + 𝛽j STDLit + 𝛽k CSVkit + 𝛽l MVlt + Indm + Yeart + vit + 𝜇it
k=1 l=1
(1)
K L
∑ ∑
Pit = 𝛼0 + 𝛿Pit−1 + 𝛽j LTDLit + 𝛽k CSVkit + 𝛽l MVlt + Indm + Yeart + vit + 𝜇it
k=1 l=1
(2)
13
K L
∑ ∑
Pit = 𝛼0 + 𝛿Pit−1 + 𝛽j TLEVRit + 𝛽k CSVkit + 𝛽l MVlt + Indm + Yeart + vit + 𝜇it
k=1 l=1
(3)
L M
∑ ∑
Pit = 𝛼0 + 𝛿Pit−1 + 𝛽j STDLit + 𝛽k STDL2it + 𝛽l CSVlit + 𝛽m MVm
t + Indn + Yeart + vit + 𝜇it
l=1 m=1
(4)
L M
∑ ∑
Pit = 𝛼0 + 𝛿Pit−1 + 𝛽j LTDLit + 𝛽k LTDL2it + 𝛽l CSVlit + 𝛽m MVm
l=1 m=1
(5)
L M
∑ ∑
Pit = 𝛼0 + 𝛿Pit−1 + 𝛽j TLEVRit + 𝛽k TLEVR2it + 𝛽l CSVlit + 𝛽m MVm
l=1 m=1
(6)
where P is the measure of firm performance expressed as SGR, Tobin’s Q, ROA,
ROE, and ROS; Pit−1 is the one-year lag of firm performance; persistent profitabil-
ity is represented by δ; the value of 𝛿 ranges from 0 to 1; a value close to 0 for the
lag of the dependent variables represents a competitive market with high adjust-
ment speed;𝛼0 is a constant term; the coefficient is 𝛽 ; STDL, LTDL, and TLEVR are
measures of financial leverage; STDL2, LTDL2, and TLEVR2 are the squared terms
of STDL, LTDL, and TLEVR, respectively, and are used to examine an inverted
U-shaped relationship; CSV represents company-specific variables (firm size, risk,
liquidity, firm age, nondebt tax shield, government-owned and foreign-owned); MV
represents macroeconomic variables (GDP, FDI, and INF); i represents individual
company and t represents time (year); vit is the unobserved individual effect; μit is
the residual time; Ind is the industry dummies; and Yeart is the time (year) dummies.
5 Findings
5.1 Diagnostic test
The sample of this study was based on unbalanced panel data; therefore, the unit
root was checked using a Fisher type (an augmented Dickey fuller (ADF)) test.
Table 3 presents the results of the ADF test. All variables are found to be stationary,
as indicated by Table 3, where the presence of a unit root in the data is rejected by
the significant p values for each variable.
Table 4 shows the results of a variance inflation factor (VIF) test, which was used
to check the presence of multicollinearity among all explanatory variables. The
values are well within the acceptable limit, i.e., VIF < 5, which affirms that mul-
ticollinearity is absent among the variables (Damodar 2003). Furthermore, a pair-
wise correlation was also applied to cross-examine the multicollinearity in Table 5.
The results only report a higher correlation between two independent variables
(STDL and TLEVR), i.e., 0.910. However, both STDL and TLEVR were examined
13
Table 3 Unit root test Company-specific variables Macroeconomic variables

Coef PV Coef PV
SGR 3027.475 0.000 GDP 1340.529 0.000

Tobin’s Q 1293.288 0.000 FDI 2196.182 0.000
ROA 2482.359 0.000 INF 2166.145 0.000
ROE 3113.635 0.000
ROS 3228.155 0.000
STDL 1465.901 0.000
LTDL 1598.980 0.000
TLEVR 1123.626 0.000
FSIZE 1031.423 0.000
RISK 1732.664 0.000
LIQ 1526.710 0.000
FAGE 585.549 0.000
NDTS 2314.198 0.000
Table 4 VIF values Variables Equation (1) Equation (2) Equation (3)
STDL 1.13
LTDL 1.10
TLEVR 1.15
FSIZE 1.46 1.37 1.44
RISK 1.06 1.07 1.07
LIQ 1.09 1.06 1.10
FAGE 1.09 1.11 1.09
NDTS 1.01 1.03 1.02
GDP 1.45 1.45 1.45
FDI 1.46 1.46 1.46
INF 1.34 1.35 1.34
GOWN 1.11 1.11 1.11
FOWN 1.09 1.11 1.09
Mean VIF 1.21 1.20 1.21
alternatively; therefore, the higher correlation between STDL and TLEVR was of no
concern.
5.2 Descriptive statistics
In Table 6, the results of the summary statistics of total variables are shown for
the 2001–2017 period. The mean value of SGR is 0.677. The SGR ranged from
− 366.018 to 1395.198. The mean value of Tobin’s Q is 1.371, which is lower than
the mean values of 2.03 and 1.77 for firms in Singapore and Malaysia, respectively
13
13
Table 5 Correlation coefficients control variables
STDL LTDL TLEVR FSIZE RISK LIQ FAGE NDTS GDP FDI INF GOWN FOWN
STDL 1.000
LTDL 0.038** 1.000
TLEVR 0.910*** 0.449*** 1.000
FSIZE − 0.263*** − 0.027** − 0.247*** 1.000
RISK − 0.083*** − 0.102*** − 0.118*** 0.032** 1.000
LIQ − 0.181*** − 0.115*** − 0.209*** − 0.034*** 0.206*** 1.000
FAGE 0.012 − 0.124*** − 0.039*** 0.157*** 0.034*** 0.031** 1.000
NDTS 0.076*** 0.139*** 0.125*** − 0.029** − 0.004 − 0.011 − 0.010 1.000
GDP − 0.059*** 0.003 − 0.052*** 0.368*** 0.045*** 0.047*** 0.265*** 0.008 1.000
FDI 0.046*** − 0.054*** 0.019 − 0.088*** − 0.010 − 0.021* − 0.054*** − 0.023* − 0.288*** 1.000
INF − 0.006 0.040*** 0.012 0.064*** − 0.021 − 0.002 0.032*** 0.010 0.137*** 0.425*** 1.000
GOWN − 0.041*** − 0.005 − 0.039*** 0.286*** 0.011 0.024* 0.085*** − 0.004 0.026** 0.001 0.010 1.000
FOWN − 0.041*** − 0.153*** − 0.100*** 0.246*** 0.123*** 0.030** − 0.018 − 0.008 0.035*** − 0.013 0.001 0.078*** 1.000
***, **, and * are indicating the significance level at 1%, 5%, and 10%, respectively
Table 6 Descriptive statistics Variables Observation Mean Std. Dev Min Max
SGR 6085 0.677 21.267 − 366.018 1395.198

Tobin’s Q 5761 1.371 3.925 0.117 216.380
ROA 6085 0.029 0.136 − 1.835 3.195
ROE 6085 0.238 1.998 − 30.019 110.886
ROS 6083 0.420 11.732 − 538.844 49.333
STDL 6085 0.499 0.478 0 10.969
LTDL 6085 0.178 0.222 0 3.937
TLEVR 6085 0.677 0.535 0.007 11.263
FSIZE 6085 14.518 1.734 8.307 20.257
RISK 5606 3.387 10.774 − 32.080 609.263
LIQ 6085 1.507 3.313 0 138.527
FAGE 6030 3.321 0.579 0 5.056
GOWN 6085 0.040 0.195 0 1
FOWN 6085 0.137 0.344 0 1
FDI 6085 0.071 0.661 − 0.960 1.300
INF 6085 1.914 0.603 0.928 3.010
(Mak and Kusnadi 2005), and higher than the mean value of 1.15 for Vietnamese
firms (Le and Phan 2017). The range of Tobin’s Q is from 0.117 to 216.380. The
mean values of ROA, ROE, and ROS are 2.9%, 23.8%, and 42%, respectively. The
ROA ranges between − 1.835 and 3.195, the ROE ranges from − 30.019 to 110.886,
and the ROS ranges between − 538.844 and 49.333. This shows that there was a sig-
nificant performance gap in profitability among Pakistani nonfinancial listed compa-
nies during the period under analysis (2001–2017).
The average mean values of STDL accounted for 49.9% of the variance, LTDL
accounted for 17.8% and TLEVR accounted for 67.7%. From the mean value of
STDL, it is observed that STDL remained a main source of financing for Pakistani
listed firms during the 2001–2017 period. This specifies that Pakistani listed firms
are financed through STDL rather than LTDL because the risk of liquidity and refi-
nancing drives firms through STDL; hence, STDL could have an important effect on
firm performance. Compared to other countries, Pakistani nonfinancial listed com-
panies are overleveraged, which can be observed from the mean values of all lever-
age measures. A lower mean value of 0.22 of financial leverage for French firms was
observed during the 1998–2009 period (de La Bruslerie and Latrous 2012). A lower
mean value of 0.334 of financial leverage for companies in 22 East Asian and West-
ern European countries was observed over the 1996–2008 period (Lin and Chang
2011). Le and Phan (2017) observed a mean value of 51.92% of financial leverage
for Vietnamese firms over the period 2007–2012, which is still lower than that of
Pakistani listed firms. Previously, Zou and Xiao (2006) observed a mean value of
0.47 for Chinese listed firms, which is also lower than the STDL of Pakistani listed
companies.
13
5.3 Empirical findings
This study observed an association between financial leverage and performance by

applying a two-step system GMM estimator. The empirical results of this study are
reported in Tables 7, 8, and 9. Table 7 provides the findings regarding the asso-
ciation between financial leverage (STDL, LTDL, and TLEVR) and performance
(SGR, Tobin’s Q, ROA, ROE, and ROS). Table 8 illustrates the nonlinear (inverted
U-shaped) relationship between financial leverage and performance. Table 9 also
provides the findings for the association between financial leverage and perfor-
mance using alternate performance indicators added for additional robustness. The
results in Tables 7, 8 and 9 are based on the dynamic regression (i.e., GMM), which
is the baseline methodology. However, the results in Table 10 are based on static
regression (FE and RE methods), which are applied to illustrate the robustness of
the relationship between financial leverage and performance. Tables 7, 8, 9, and 10
have as many models as the numbers of dependent variables are in each table. Each
model in Tables 7 and 9 examines Eqs. (1)–(3), where Eq. (1) measures the impact
of STDL on performance, Eq. (2) measures the impact of LTDL on performance,
and Eq. (3) measures the impact of TLEVR on performance. Each model in Table 8
examines Eqs. (4)–(6), where Eq. (4) measures the inverted U-shaped relationship
between SDTL and performance, Eq. (5) measures the inverted U-shaped relation-
ship between LDTL and performance, and Eq. (6) measures the inverted U-shaped
relationship between TLEVR and firm performance. Each model in Table 10 exam-
ines Eqs. (7)–(9), which are based on static regression and measure the relationship
between financial leverage and performance.
The significant coefficients of the lagged dependent variables in Tables 7, 8, and
9 show that there exists a positive association between current-year performance and
past-year performance, indicating a dynamic relationship among our tested equa-
tions. The significant values of the F-statistics of each equation tested in Tables 7,
8, and 9 indicate the joint significance of all models. The results report the insignifi-
cant p values of AR(1) and AR(2) in all estimated models of GMM, which lead to
the acceptance of the null of no serial correlation (see Tables 7, 8, and 9). Further-
more, in all estimated models, the p values of the Hansen J-statistics are insignifi-
cant, which indicates the use of valid instruments (see Tables 7, 8, and 9).
5.3.1 Impact of financial leverage on performance
The outcomes regarding the impact of financial leverage on the performance of

Pakistani listed firms are reported in Table 7, where five performance indicators,
i.e., SGR, Tobin’s Q, ROA, ROE, and ROS, are used. Equations (1), (2), and (3)
demonstrate the results for STDL, LTDL, and TLEVR, respectively. As per Eq. (1),
STDL has a significant negative impact ( − 0.491, p < 1%) on SGR, a significant
negative impact ( − 1.281, p < 5%) on Tobin’s Q, a significant negative impact
( − 0.382, p < 1%) on ROA, a significant negative impact ( − 0.202, p < 1%) on ROE,
and a significant negative impact ( − 0.772, p < 5%) on ROS. This indicates that a
one-unit increase in the STDL decreases the SGR by 0.491 and decreases Tobin’s
Q by 1.281. Likewise, a one-unit increase in STDL decreases their ROA by 0.382,
13
Table 7 The impact of financial leverage on firm performance
SGR Tobin’s Q ROA ROE ROS
Equation Equation Equation Equation Equation Equation Equation Equation Equation Equation Equation Equation Equation Equation Equation
(1) (2) (3) (1) (2) (3) (1) (2) (3) (1) (2) (3) (1) (2) (3)
Dept-1 0.045 0.005* 0.057*** 0.030 0.087 0.151 0.117 0.061 0.064 0.002 0.006 0.019 0.001 0.000 0.001*
(0.047) (0.003) (0.023) (0.187) (0.216) (0.187) (0.120) (0.101) (0.119) (0.136) (0.020) (0.105) (0.002) (0.000) (0.001)
STDL − 0.491*** − 1.281** − 0.382*** − 0.202*** − 0.772**
(0.195) (0.619) (0.129) (0.081) (0.386)
LTDL –0.339* –0.098 –0.229** –0.390* –0.584**
(0.198) (0.608) (0.112) (0.227) (0.289)

TLEVR − 0.342* − 1.260** − 0.118** − 0.355** − 0.948***
(0.187) (0.650) (0.056) (0.156) (0.267)
FSIZE − 0.121 0.030 − 0.101* − 0.306** − 0.080 − 0.244 − 0.013 − 0.003 − 0.035** − 0.090* − 0.025 − 0.038 − 0.022 0.029 − 0.027
(0.089) (0.054) (0.061) (0.143) (0.107) (0.160) (0.018) (0.014) (0.017) (0.047) (0.055) (0.056) (0.034) (0.037) (0.046)
RISK − 0.010 − 0.061 − 0.002 0.355*** 0.324*** 0.306*** 0.058*** 0.057*** 0.047*** − 0.018 − 0.001 − 0.042 0.024 0.001 0.000
(0.034) (0.039) (0.002) (0.070) (0.073) (0.078) (0.018) (0.011) (0.009) (0.018) (0.003) (0.028) (0.027) (0.001) (0.001)
LIQ − 0.136 0.075 − 0.099 − 1.020*** − 0.348** − 0.768*** − 0.189*** − 0.072*** − 0.094*** − 0.065** 0.005 − 0.158** − 0.206** − 0.048** − 0.121***
(0.096) (0.046) (0.070) (0.293) (0.153) ( 0 .195) (0.066) (0.015) (0.023) (0.029) (0.005) (0.071) (0.088) (0.023) (0.047)
FAGE 0.084 0.219 0.049 − 2.383*** − 1.482 − 1.416 − 0.548** 0.032 − 0.028 − 0.469 − 0.303 − 0.986*** − 0.095 − 0.116 − 0.129
(0.151) (0.141) (0.112) (0.814) (1.431) (1.107) (0.224) (0.092) (0.028) (0.533) (0.376) (0.347) (0.238) (0.289) (0.161)
NDTS − 18.100*** 4.628 − 17.409** − 11.102** 58.966 44.339 − 0.690* − 9.635*** − 5.878*** − 21.397*** 11.484 − 11.098** − 2.409 − 10.079** − 16.871***
(7.318) (4.296) (7.840) (4.892) (43.693) (27.883) (0.367) (2.715) (2.241) (8.338) (7.204) (4.928) (2.081) (5.210) (6.110)
GDP 0.115** − 0.015 0.106** 0.523*** 0.175 0.294* 0.077 0.008 0.029*** 0.146** 0.040 0.165*** 0.040 0.034 0.089***
(0.053) (0.026) (0.047) (0.142) (0.186) (0.180) (13.105) (0.016) (0.010) (0.071) (0.041) (0.049) (0.041) (0.029) (0.033)
FDI 0.081* 0.099** 0.101 0.205** 0.155 0.036 − 0.002 − 0.010 − 0.017 0.042 0.048 0.004 − 0.011 0.057 0.074
(0.042) (0.043) (0.083) (0.088) (0.151) (0.112) (57.108) (0.015) (0.011) (0.052) (0.039) (0.031) (0.031) (0.055) (0.062)
INF − 0.154** − 0.079 − 0.164 − 0.467*** − 0.405*** − 0.250** 0.010 0.037 0.028 − 0.143* − 0.010 − 0.009 0.048 − 0.188* − 0.168*
(0.079) (0.066) (0.119) (0.117) (0.162) (0.127) (152.654) (0.029) (0.021) (0.080) (0.037) (0.042) (0.045) (0.100) (0.097)
GOWN 1.733 0.623 1.666** 7.276*** 4.012** 6.562** 0.622** − 0.170 0.056 1.659** 0.036*** 1.269 1.361* 0.278 0.580
(1.130) (0.692) (0.829) (2.258) (1.727) (2.957) (0.273) (0.185) (0.129) (0.680) (0.833) (0.838) (0.813) (0.434) (0.535)
FOWN 2.194** 1.359** 2.107*** 5.365 3.078** 3.458* − 0.225 − 0.094 − 0.071 3.032*** 0.948 3.177*** 0.237 0.134 0.508
(0.936) (0.611) (0.670) (1.860) (1.570) (2.109) (0.266) (0.172) (0.134) (0.642) (0.701) (0.800) (0.682) (0.238) (0.538)
13
Table 7 (continued)
13
(1) (2) (3) (1) (2) (3) (1) (2) (3) (1) (2) (3) (1) (2) (3)
Observa- 3178 3242 3588 3901 3240 3239 4444 3864 3899 3528 4444 3527 3297 3018 3241
tions
Compa- 374 345 391 394 378 382 330 327 328 397 330 397 378 295 345
nies
Instru- 61 61 61 62 61 60 61 61 61 61 71 61 61 61 61
ments
F-Statis- 9.19*** 14.18*** 7.31*** 10.82*** 10.03*** 9.01*** 3.59*** 3.27*** 5.31*** 3.75*** 1.86*** 4.61*** 1.69*** 1.49*** 1.66***
tics
AR(1) (p − 1.12 − 1.06 − 1.12 − 1.00 − 0.83 − 0.89 − 0.17 − 0.97 − 0.94 − 1.03 − 1.10 − 1.21 − 1.10 − 1.23 − assss1.39
value) (0.264) (0.289) (0.265) (0.319) (0.408) (0.372) (0.867) (0.331) (0.347) (0.301) (0.271) (0.228) (0.273) (0.220) (0.165)
AR(2) (p − 0.46 0.56 − 0.25 − 0.97 − 0.82 − 0.88 − 1.29 − 0.96 − 0.94 − 0.94 − 0.85 − 0.91 − 0.84 − 0.90 − 0.94
value) (0.647) (0.578) (0.801) (0.332) (0.414) (0.379) (0.199) (0.335) (0.348) (0.348) (0.396) (0.363) (0.401) (0.370) (0.346)
Hansen 15.96 17.27 10.08 23.10 19.45 20.26 18.94 24.38 21.62 17.05 35.92 20.43 21.73 20.89 15.05
J (p (0.527) (0.436) (0.900) (0.187) (0.303) (0.209) (0.332) (0.109) (0.200) (0.451) (0.117) (0.253) (0.195) (0.231) (0.592)
value)
Two-step system GMM estimator was applied on unbalanced dynamic panel data. 1%, 5%, 10% significance levels are described by ***, **, *, respectively. We treated
financial leverage (STDL, LTDL, and TLEVR) as endogenous variables to deal with endogeneity. Joint significance of all variables is indicated by F-statistic in this study.
For serial correlation, Arellano-Bond test was applied in which AR(1) indicates first-order serial correlation and AR(2) indicates second-order serial correlation where the
insignificant p values of AR(2) have shown that the data have no serial correlation problem. The insignificant p values of Hansen J indicate that the use of instruments was
valid
Table 8 Inverted U-shaped relationship between financial leverage and performance
SGR Tobin’s Q ROA
Equation Equation Equation Equation Equation Equation Equation Equation Equation
(4) (5) (6) (4) (5) (6) (4) (5) (6)
Dept-1 0.008* 0.013* 0.007* 0.003 0.002 0.087 0.009 0.387** 0.177
(0.004) (0.008) (0.004) (0.045) (0.088) (0.058) (0.209) (0.171) (0.165)
STDL 6.432*** 13.251*** 0.485**
(2.618) (4.656) (0.248)
STDL2 − 7.938*** − 15.423*** − 0.078**
(2.938) (5.677) (0.035)

LTDL 2.235 3.180*** 1.725**
(2.136) (0.908) (0.789)
LTDL2 − 6.076 − 3.661** − 3.819**
(5.134) (1.713) (1.831)
TLEVR 7.951** 7.894*** 1.092**
(3.781) (2.581) (0.500)
TLEVR2 − 8.023** − 6.055*** − 1.064**
(3.541) (2.245) (0.446)
FSIZE − 0.012 − 0.014 − 0.043 0.114 − 0.031 − 0.021 − 0.037 − 0.022* − 0.019
(0.061) (0.053) (0.065) (0.071) (0.057) (0.077) (0.028) (0.013) (0.012)
RISK − 0.030 − 0.035 − 0.033 0.320*** 0.365*** 0.283*** 0.025** 0.024*** 0.026**
(0.024) (0.023) (0.032) (0.040) (0.053) (0.052) (0.011) (0.009) (0.013)
LIQ 0.065 0.044 0.079 − 0.240** − 0.341*** 0.030 − 0.034 − 0.024* − 0.026***
(0.047) (0.027) (0.051) (0.101) (0.111) (0.131) (0.038) (0.012) (0.011)
FAGE 0.690*** 0.635*** 0.705* − 0.142 0.610 0.440 0.486* − 0.028 − 0.014
(0.261) (0.196) (0.367) (0.179) (0.412) (0.714) (0.261) (0.107) (0.024)
NDTS − 6.391** − 2.346 2.915 − 0.368 − 16.235*** − 9.096 − 8.171* − 4.529*** − 7.575***
(2.853) (1.978) (6.392) (0.794) (5.936) (6.337) (4.644) (1.814) (2.440)
GDP − 0.072 − 0.036 − 0.099 − 0.093 − 0.021 − 0.093 − 0.035 0.014 0.010
(0.045) (0.026) (0.066) (0.057) (0.043) (0.101) (0.027) (0.013) (0.010)
13
Table 8 (continued)
SGR Tobin’s Q ROA
Equation Equation Equation Equation Equation Equation Equation Equation Equation
13
(4) (5) (6) (4) (5) (6) (4) (5) (6)
FDI 0.117*** 0.117*** 0.087** 0.065 0.123* 0.125** − 0.006 0.010 − 0.002
(0.034) (0.035) (0.037) (0.061) (0.071) (0.060) (0.020) (0.010) (0.010)
INF − 0.092* − 0.098 0.018 − 0.298*** − 0.191** − 0.238*** 0.041 0.025 0.030
(0.052) (0.046) (0.060) (0.070) (0.091) (0.082) (0.043) (0.018) (0.019)
GOWN 0.488 0.408 0.968 1.522* − 0.039 0.268 − 0.027 0.119 0.010
(0.954) (0.914) (1.045) (0.875) (0.340) (1.140) (0.127) (0.126) (0.073)
FOWN 1.309* 1.145** 1.116* − 0.695 0.249 0.402 0.080 0.152 0.118
(0.773) (0.543) (0.664) (0.922) (0.226) (1.202) (0.086) (0.162) (0.113)
Observations 3766 3242 3767 2630 2314 2575 2986 2694 3422
Companies 363 345 363 328 313 336 381 314 323
Instruments 61 61 61 67 66 64 61 61 67
F-Statistics 6.94*** 9.80*** 7.29*** 36.67*** 18.48*** 19.68*** 1.46** 5.30*** 3.60***
AR(1) (p value) − 1.11 − 1.06 − 1.07 − 0.89 − 0.96 − 0.11 − 0.86 − 1.00 − 0.99
(0.268) (0.291) (0.284) (0.372) (0.338) (0.915) (0.389) (0.315) (0.323)
AR(2) (p value) − 0.76 1.11 − 0.87 − 0.94 − 0.94 − 0.94 − 0.85 − 0.91 − 1.02
(0.450) (0.266) (0.385) (0.349) (0.348) (0.347) (0.394) (0.363) (0.309)
Hansen J (p value) 19.51 21.20 16.64 27.02 25.41 22.53 22.68 21.45 27.25
(0.243) (0.171) (0.409) (0.210) (0.230) (0.259) (0.123) (0.162) (0.202)
valid
Table 9 Robustness check (change in dependent variables)
SGR1 EPS PM NPM
Equation Equation Equation Equation Equation Equation Equation Equation Equation Equation Equation Equation
(1) (2) (3) (1) (2) (3) (1) (2) (3) (1) (2) (3)
Dept-1 1.026*** 1.024*** 1.025*** 0.397*** 0.355*** 0.323*** 0.049 0.018 0.001 0.000 0.000 0.001*
(0.003) (0.002) (0.003) (0.095) (0.112) (0.066) (0.098) (0.079) (0.075) (0.001) (0.000) (0.000)
STDL − 1.664*** − 20.370** − 0.664*** − 0.503***
(0.631) (9.589) (0.120) (0.195)
LTDL − 0.362 − 18.282 − 0.126* − 0.441**
(1.303) (20.900) (0.074) (0.199)

TLEVR − 1.884*** − 12.136** − 0.235*** − 0.640***
(0.743) (5.780) (0.059) (0.149)
FSIZE − 0.971*** − 0.343 − .836*** − 6.869** − 4.059 − 3.580 − 0.068*** − 0.037** − 0.063*** − 0.072*** − 0.005 − 0.034*
(0.339) (0.356) (0.329) (3.405) (4.227) (3.190) (0.023) (0.018) (0.024) (0.026) (0.032) (0.021)
RISK − 0.0156 − 0.337 − 0.003 0.655 − 0.116 − 0.195 0.008** − 0.001 0.004 0.001 0.000 0.000
(0.012) (0.211) (0.008) (0.714) (0.156) (1.301) (0.004) (0.001) (0.005) (0.008) (0.001) (0.000)
LIQ − 0.874** 0.413 − 0.954** − 6.081** 2.523 − 8.457 − 0.134*** 0.003 − 0.092*** − 0.118*** − 0.080** − 0.108***
(0.401) (0.436) (0.422) (2.889) (3.049) (6.054) (0.032) (0.022) (0.016) (0.037) (0.034) (0.037)
FAGE 0.218 0.472 –0.367 –28.906 –6.259 6.219 0.057 –0.031 0.040 0.261 0.023 –0.021
(0.587) (0.810) (0.644) (26.600) (7.183) (6.067) (0.046) (0.163) (0.048) (0.235) (0.081) (0.038)
NDTS − 42.039* 24.407 − 143.760*** − 1459.663*** − 1920.092*** − 1079.367** − 5.548* − 6.908*** − 7.877** − 0.725 − 10.388** − 11.580***
(22.767) (84.903) (46.911) (502.100) (781.258) (453.665) (3.005) (2.522) (3.496) (3.118) (5.349) (2.770)
GDP 0.599*** 0.065 0.798*** 8.838 5.766* 3.771* 0.049*** 0.035* 0.051*** 0.016 0.014 0.047***
(0.200) (0.303) (0.271) (394.834) (3.083) (2.259) (0.017) (0.019) (0.018) (0.031) (0.023) (0.015)
FDI 0.139 − 0.221 0.483 1.086 − 0.621 0.367 0.025 − 0.008 0.026 − 0.003 − 0.012 0.009
(0.169) (0.546) (0.383) (1720.449) (7.076) (4.713) (0.018) (0.022) (0.019) (0.020) (0.032) (0.020)
INF − 0.489 0.498 − 1.089* 0.894 − 5.531 − 6.358 − 0.003 − 0.044 − 0.079** 0.034 0.067 0.070
(0.313) (1.030) (0.616) (4598.877) (8.214) (5.670) (0.031) (0.034) (0.038) (0.026) (0.075) (0.046)
Govern- 13.640*** 8.920* 7.767** 42.861 21.265 66.658 1.268*** 0.504** 1.266*** 1.100*** 0.708** 0.792***
ment- (5.193) (4.669) (3.583) (53.752) (32.708) (41.195) (0.265) (0.249) (0.282) (0.359) (0.350) (0.238)
owned
Foreign- 14.817*** 10.928** 11.866*** 86.534** 52.975 96.765*** 1.099*** 0.921*** 1.127*** 0.692*** 0.484* 0.485**
13
owned (4.036) (5.183) (4.256) (41.438) (38.512) (36.899) (0.246) (0.243) (0.263) (0.231) (0.255) (0.203)
Table 9 (continued)
SGR1 EPS PM NPM
Equation Equation Equation Equation Equation Equation Equation Equation Equation Equation Equation Equation
13
(1) (2) (3) (1) (2) (3) (1) (2) (3) (1) (2) (3)
Observa- 3649 3649 3649 4447 4447 3328 3408 3526 3518 3549 3210 3206
tions
Compa- 394 394 394 330 330 382 382 397 396 388 344 344
nies
Instru- 61 57 61 61 68 61 63 65 68 66 68 62
ments
F-Statis- 2552.36*** 11,220.79*** 3137.69*** 2.26*** 1.60*** 2.35*** 3.07*** 1.96*** 2.33*** 2.13*** 1.66 *** 3.12***
tics
AR(1) (p 0.85 0.97 − 0.25 − 0.96 − 0.94 − 0.94 − 0.89 − 0.94 − 0.92 − 1.02 − 1.21 − v1.23
value) (0.396) (0.333) (0.804) (0.336) (0.347) (0.346) (0.373) (0.345) (0.358) (0.305) (0.228) (0.220)
AR(2) (p − 1.01 − 1.00 − 1.10 − 0.95 − 0.93 − 0.93 − 0.89 − 0.93 − 0.91 − 0.77 − 0.90 − 0.98
value) (0.313) (0.316) (0.271) (0.343) (0.353) (0.353) (0.376) (0.352) (0.363) (0.442) (0.366) (0.326)
Hansen 20.82 7.34 16.98 20.80 24.48 14.57 19.57 23.53 31.76 28.72 25.74 21.88
J (p (0.235) (0.884) (0.456) (0.235) (0.434) (0.626) (0.421) (0.316) (0.133) ( 0.153) (0.367) (0.237)
value)
valid
Table 10 Robustness check (change of methodology)
(7) RE (8) (9) (7) (8) (9) (7) (8) (9) (7) (8) (9) (7) (8) (9)
FE FE FE RE RE FE FE FE RE RE RE FE FE FE
STDL 0.268 − 1.219*** − 0.073*** − 0.006*** − 2.189***

(0.403) (0.160) (0.024) (0.004) (0.579)
LTDL 1.991 − 1.239*** − 0.073*** − 0.108** − 2.601***
(1.620) (0.136) (0.011) (0.045) (1.036)
TLEVR − 1.184** − 1.322*** − 0.084*** − 0.026 − 1.203**

(0.571) (0.118) (0.006) (0.040) (0.541)
FSIZE 0.036 − 0.260 − 0.062 0.014 − 0.116** 0.048* − 0.004 0.008** − 0.006 0.052*** 0.052*** 0.050*** 1.289*** 1.703*** 1.447***
(0.192) (0.393) (0.410) (0.054) (0.051) (0.028) (0.008) (0.004) (0.004) (0.016) (0.014) (0.016) (0.377) (0.364) (0.377)
RISK − 0.000 0.001 0.002 0.363*** 0.361*** 0.363*** 0.001*** 0.001*** 0.001*** 0.002 0.002 0.002 0.032** 0.036** 0.033**
(0.003) (0.003) (0.003) (0.008) (0.008) (0.007) (0.001) (0.001) (0.001) (0.002) (0.002) (0.002) (0.016) (0.016) (0.016)
LIQ − 0.016 − 0.010 0.005 − 0.208*** − 0.223*** − 0.203*** − 0.001*** − 0.001 − 0.002*** − 0.009 − 0.010 − 0.010 − 0.540*** − 0.511*** − 0.528***
(0.031) (0.015) (0.014) (0.028) (0.025) (0.030) (0.001) (0.001) (0.001) (0.007) (0.007) (0.007) (0.053) (0.052) (0.053)
FAGE 0.155 1.833*** 1.518** − 0.136 0.064 − 0.038 0.049*** 0.028** 0.046*** − 0.061 − 0.066 − 0.061 1.048 0.742 0.751
(0.430) (0.699) (0.749) (0.247) (0.072) (0.063) (0.014) (0.014) (0.014) (0.050) (0.051) (0.050) (1.351) (1.348) (1.349)
NDTS 0.036 − 0.022 0.022 0.043*** − 0.005 − 0.003 − 0.011*** − 0.008*** − 0.009*** 0.005 0.011* 0.008 0.011 − 0.035 0.065
(0.027) (0.062) (0.030) (0.003) (0.007) (0.005) (0.003) (0.003) (0.003) (0.004) (0.006) (0.005) (0.276) (0.278) (0.276)
GDP 0.019 4.168** 3.964** − 0.344 0.100*** 0.013 0.007 − 0.005 0.010 − 0.049** − 0.049** − 0.048* 1.859 1.450 1.693
(0.192) (1.886) (1.889) (0.278) (0.027) (0.016) (0.031) (0.031) (0.030) (0.025) (0.024) (0.025) (2.898) (2.898) (2.900)
FDI 0.367 − 24.030** − 23.219** 3.382** 1.037*** 0.995*** − 0.127 − 0.074 − 0.126 − 0.844** − 0.850** − 0.847** − 21.326 − 20.170 − 20.606
(1.609) (10.750) (10.761) (1.513) (0.169) (0.135) (0.167) (0.168) (0.165) (0.425) (0.426) (0.424) (15.734) (15.743) (15.747)
INF − 0.675 19.826** 19.037** − 2.921** − 0.821*** − 0.883*** 0.116 0.065 0.115 0.688* 0.691* 0.691* 19.945 18.836 19.242
(1.703) (9.276) (9.292) (1.383) (0.187) (0.163) (0.149) (0.151) (0.148) (0.410) (0.411) (0.410) (14.111) (14.118) (14.122)
GOWN Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
FOWN Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
Industry Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
effect
13
Table 10 (continued)
13
(7) RE (8) (9) (7) (8) (9) (7) (8) (9) (7) (8) (9) (7) (8) (9)
FE FE FE RE RE FE FE FE RE RE RE FE FE FE
Constant − 102.679** − 161.512** − 156.382** 15.392 17.287 19.558 − 0.458 − 0.129 − 0.461 − 0.257 − 0.687 − 0.379 − 109.713 − 102.16 − 105.19
(47.982) (71.745) (71.837) (19.317) (21.872) (25.479) (1.155) (1.166) (1.147) (1.752) (1.354) (1.075) (109.058) (109.120) (109.15)
Observa- 5557 5557 5557 5557 5557 5557 5557 5557 5557 5557 5557 5557 5557 5557 5557
tions
Compa- 414 414 414 414 414 414 414 414 414 414 414 414 414 414 414
nies
F-Statis- 242.33*** 1.90*** 1.61** 714.23*** 19,913.62*** 30,268.13*** 11.87*** 7.19*** 15.33*** 830.76*** 790.04*** 825.92*** 6.82*** 6.45*** 6.38***
tics
R-Square 0.013 0.003 0.003 0.947 0.941 0.950 0.049 0.165 0.062 0.110 0.110 0.111 0.029 0.027 0.027
Hausman23.70 74.62*** 83.11*** 38.54*** 1.87 24.76 45.20*** 85.53*** 78.16*** 20.98 19.27 19.59 40.38*** 47.80*** 30.44***
(0.308) (0.000) (0.000) (0.005) (1.000) (0.211) (0.001) (0.000) (0.000) (0.460) (0.568) (0.547) (0.007) (0.001) (0.004)
The fixed effect (FE) and random effect (RE) regression between STDL, LTDL, TLEVR, SGR, Tobin’s Q, ROA, ROE, and ROS. Parentheses holds robust standard errors
***, **, and * are indicating the significance level at 1%, 5%, and 10%, respectively. The joint significance of the model can be indicated by F-statistics
decreases ROE by 0.202, and decreases their ROS by 0.772. Thus, this shows that
there exists a negative association between STDL and the performance of Pakistani
listed firms. STDL financing is considered suitable and flexible due to its nature.
Therefore, there is a possibility that the performance of companies relying on STDL
may be affected by the rate of interest instability. This finding indicates that the full
benefits of STDLs are not known until they are used for a long period, and firms
must postpone profitable projects (Dalci 2018), exacerbating the negative relation
between STDL and the performance of Pakistani listed companies. The same nega-
tive association between STDL and performance was found by Datta et al. (2005),
Dawar (2014), Le and Phan (2017), and Zhang and Chen (2017).
According to Eq. (2), LTDL has a significant negative impact ( − 0.339, p < 10%)
on SGR, a negative impact ( − 0.098, p > 10%) on Tobin’s Q, a significant negative
impact ( − 0.229, p < 5%) on ROA, a significant negative impact ( − 0.390, p < 10%)
on ROE, and a significant negative impact ( − 0.584, p < 5%) on ROS. This indicates
that a one-unit increase in LTDL decreases SGR by 0.339 and a one-unit increase
in LTDL decreases Tobin’s Q by 0.098. Likewise, a one-unit increase in LTDL
decreases ROA by 0.229, decreases ROE by 0.390, and decreases ROS by 0.584.
Thus, there exists a negative association between LTDL and the performance of
Pakistani listed companies. According to the descriptive statistics of this study, most
of the financial leverage of Pakistani listed companies consists of STDL, while the
level of LTDL is extremely low. This is because, when comparing the capital mar-
kets of advanced countries, the capital markets in Pakistan are incomplete and ineffi-
cient (Ahsan 2016), similar to those in other emerging countries (Dalci 2018; Dawar
2014; Le and Phan 2017). Furthermore, Pakistan is also characterized by an imma-
ture bond market and property rights, and the legal system of Pakistan is incom-
plete and weak. Consequently, Pakistani listed companies suffer from a high level
of information asymmetry (Ahsan 2016; Harris and Raviv 1991), exacerbating the
negative relationship between LTDL and the performance of Pakistani listed firms.
The same negative association between LTDL and firm performance was found by
Dawar (2014), Danso (2019), and Yazdanfar (2015).
As per Eq. (3), TLEVR has a significant negative impact ( − 0.342, p < 10%) on
SGR, a significant negative impact ( − 1.260, p < 5%) on Tobin’s Q, a significant
negative impact ( − 0.118, p < 5%) on ROA, a significant negative impact ( − 0.355,
p < 5%) on ROE, and a significant negative impact ( − 0.948, p < 1%) on ROS. This
indicates that a one-unit increase in TLEVR decreases SGR by 0.342 and decreases
Tobin’s Q by 1.260. Likewise, a one-unit increase in TLEVR decreases ROA by
0.118, decreases ROE by 0.355, and decreases ROS by 0.948. Thus, this indicates a
significant negative association of TLEVR with the performance of Pakistani listed
companies. Previously, Harris and Raviv (1991) explained that underestimating the
insolvency costs of liquidation may lead firms to attain higher-than-suitable debt
level. Thus, firm performance will decrease due to the higher debt ratio. Further-
more, a heavy cash flow due to debt can cause managers to assume discretionary
behavior, which negatively affects performance. Additionally, Stulz (1990) argued
that firm cash flows and reserves for new profitable projects could be reduced due
to paying interest against debts, which negatively affects firm performance. There-
fore, the negative relation between TLEVR and the performance of Pakistani listed
13
companies is exacerbated. Previously, Zhang and Chen (2017), Vithessonthi and

Tongurai (2015), Bae et al. (2017), and Danso (2019) found a negative association
between TLEVR with the performance of firms in different countries. Thus, H1 is
accepted.
Concerning the results for company-specific variables, Table 7 reports a signifi-
cant negative relationship between firm size (FSIZE) and the performance of Paki-
stani listed companies, which is consistent with the studies by Pi and Timme (1993)
and Dalci (2018). It suggests that possible agency problems are relevant for owners
and managers. According to this, a larger company size affects the management’s
ability to control the behaviors of employees and thus decreases performance. The
results report a positive significant association between risk and firm performance,
which is consistent with Davydov (2016). Liquidity (LIQ) is found to have a sig-
nificant negative association with firm performance. Firm age (FAGE) and the non-
debt tax shield (NDTS) are found to be significantly negatively associated with firm
performance, which is consistent with Dawar (2014), Vithessonthi and Tongurai
(2015), Davydov (2016), Bae et al. (2017), and Zhang and Chen (2017). The results
regarding the ownership structure indicate that firms with government and foreign
ownership have higher performance, i.e., SGR, Tobin’s Q, ROA, ROE, and ROS,
than firms with private ownership. Among macroeconomic variables, GDP and FDI
are found to have a significant positive impact on performance (Dalci 2018; Vithes-
sonthi and Tongurai 2015), while inflation (INF) is found to have a significant nega-
tive impact on the performance of Pakistani listed firms.
5.3.2 Inverted U‑shaped relationship between financial leverage and firm

performance
The results regarding the inverted U-shaped association between financial leverage
and the performance of Pakistani listed companies are reported in Table 8. Three
performance indicators, i.e., SGR, Tobin’s Q, and ROA, are used as dependent vari-
ables. Equations (4)–(6) demonstrate the results for STDL, LTDL, and TLEVR,
respectively. As per Eq. 4, STDL shows a significant positive impact (6.432, p < 1%)
on SGR, a significant positive impact (13.251, p < 1%) on Tobin’s Q, and a signifi-
cant positive impact (0.485, p < 5%) on ROA, while the squared value of S TDL2
shows a significant negative impact ( − 7.938, p < 1%) on SGR, a significant negative
impact ( − 15.423, p < 1%) on Tobin’s Q, and a significant negative impact ( − 0.078,
p < 5%) on ROA. This finding indicates that an increase in STDL increases perfor-
mance up to a certain level. However, because of decreasing marginal utility, after
reaching a certain level, a further increase in STDL significantly decreases the per-
formance, i.e., SGR, Tobin’s Q, and ROA, of Pakistani companies. Thus, the results
confirm the inverted U-shaped association between STDLs and the performance of
Pakistani nonfinancial listed companies.
Equation 5 reports that LTDL has a positive impact (2.235, p > 10%) on SGR, a
significant positive impact (3.180, p < 1%) on Tobin’s Q, and a significant positive
impact (1.725, p < 5%) on ROA, while a squared value of LTDL2 has a negative
impact ( − 6.076, p > 10%) on SGR, a significant negative impact ( − 3.661, p < 5%)
on Tobin’s Q, and a significant negative impact ( − 3.819, p < 5%) on ROA. This
13
indicates that similar to STDL, an increase in LTDL increases the performance of

Pakistani listed companies up to a certain level; afterward, a further unit increase
in LTDL decreases the performance significantly, i.e., SGR, Tobin’s Q, and ROA,
of Pakistani companies. Therefore, our study confirms the inverted U-shaped rela-
tionship between LTDL and performance. Similar to Eqs. 4 and 5, Eq. 6 also shows
that TLEVR has a significant positive impact (7.951, p < 5%) on SGR, a signifi-
cant positive impact (7.894, p < 1%) on Tobin’s Q, and a significant positive impact
(1.092, p < 5%) on ROA, while the squared value of total leverage (TLEVR2) has a
significant negative impact ( − 8.023, p < 5%) on SGR, a significant negative impact
(–6.055, p < 1%) on Tobin’s Q, and a significant negative impact ( − 1.064, p < 5%)
on ROA. This finding indicates that an inverted U-shaped association exists between
TLEVR and firm performance.
The results reported in Table 8 demonstrate that regardless of using STDL,
LTDL, and TLEVR, our study reports almost the same effect of leverage on the per-
formance of Pakistani listed companies. The results report that STDL, LTDL, and
TLEVR increase SGR, Tobin’s Q, and ROA up to a specific level. However, after
reaching that certain level, a further increase in financial leverage decreases the sus-
tainable growth (SGR), market performance (Tobin’s Q), and profitability (ROA) of
Pakistani listed companies. Thus, hypothesis H2 is accepted. Previously, Jaisinghani
and Kanjilal (2017), Cheng et al. (2010), Le and Phan (2017), Pattitoni et al. (2014),
Davydov (2016), Bae et al. (2017), and Dalci (2018) also found the same inverted
U-shaped association between financial leverage and the performance of companies
in different countries.
5.3.3 Robustness check (change in dependent variables)
To ensure the robustness of our study, we conducted an additional test by replac-

ing the performance indicators. Following Zhang and Chen (2017), we used Van
Horne’s static model of the sustainable growth rate (SGR) denoted by SGR1, i.e.,
retained profits*net profit rate*(1 + debt/equity ratio)*{1/(total assets/total sale)–1}.
We replaced Tobin’s Q with earnings per share (EPS), which is measured as net
income divided by the number of shares outstanding. We replaced ROA with profit
margin (PM), which is measured as profit before tax divided by total assets, and
replaced ROE with net profit margin (NPM), which is measured as net income
divided by total sales.
The GMM results of the robustness check are also described in Table 9. Accord-
ing to Eq. 1, STDL is still found to have a significant negative impact ( − 1.664,
p < 1%) on SGR1, a significant negative impact ( − 20.370, p < 5%) on EPS, a
significant negative impact (–0.664, p < 1%) on PM, and a significant negative
impact ( − 0.503, p < 1%) on NPM. This indicates that a one-unit increase in STDL
decreases SGR1, EPS, PM, and NPM by 1.664, 20.370, 0.664, and 0.503, respec-
tively. As per Eq. 2, LTDL still has a negative impact ( − 0.362, p > 10%) on SGR1, a
negative impact ( − 18.282, p > 10%) on EPS, a significant negative impact ( − 0.126,
p < 10%) on PM, and a significant negative impact ( − 0.441, p < 5%) on NPM. This
finding indicates that a one-unit increase in LTDL decreases SGR1, EPS, PM, and
NPM by 0.362, 18.282, 0.126, and 0.441, respectively. Similarly, according to Eq. 3,
13
TLEVR still reports a significant negative impact ( − 1.884, p < 1%) on SGR1, a sig-
nificant negative impact ( − 12.136, p < 5%) on EPS, a significant negative impact
( − 0.235, p < 1%) on PM, and a significant negative impact ( − 0.640, p < 1%) on
NPM. This indicates that a one-unit increase in TLEVR decreases SGR1, EPS, PM,
and NPM by 1.884, 12.136, 0.235, and 0.640, respectively. Thus, this study con-
firms that even after replacing the performance indicators, there exists a significant
relationship between financial leverage, i.e., STDL, LTDL, and TLEVR, and the
performance of Pakistani companies. Moreover, our results regarding the company-
specific and macroeconomic variables are consistent with those in Table 7.
5.3.4 Robustness check (change of methodology)
For further robustness, we applied static methods, i.e., fixed effects (FE) and random
effects (RE), using the performance indicators already tested in Table 7. For this
purpose, the following econometric equations are developed. Equation (7) meas-
ures the impact of STDL on firm performance. Equation (8) measures the impact of
LTDL on firm performance. Equation (9) measures the impact of TLEVR on firm
performance. The regression equations based on the FE and RE methods are given
as follows:
K L
∑ ∑
Pit = α0 + 𝛽j STDLit + βk CSVkit + βl MVlt + Indm + Yeart + 𝜀it (7)
k=1 l=1
K L
∑ ∑
Pit = α0 + 𝛽j LTDLit + βk CSVkit + βl MVlt + Indm + Yeart + 𝜀it (8)
k=1 l=1
K L
∑ ∑
Pit = α0 + 𝛽j TLEVRit + 𝛽k CSVkit + βl MVlt + Indm + Yeart + 𝜀it (9)
k=1 l=1
In Eqs. (7)–(9), Pit is the dependent variable. α0 is the constant term, βj is the coef-
ficient, εit here is the error term, Indm is used for the industry effect, i represents the
individual company, and t represents time (year). Yeart is a time (year) dummy. CSV
represents the company-specific variables, and MV represents the macroeconomic
variables.
The results based on static regressions are presented in Table 10. Robust stand-
ard errors were applied to address the possible autocorrelations and heteroskedastic-
ity. The appropriateness between FE and RE for each equation was checked through
application of the Hausman specification test (Hausman 1978). The p < 0.05 of the
Hausman Chi2 indicates that FE is appropriate, and the p > 0.05 of the Hausman
Chi2 indicates that RE is appropriate (Haris et al. 2019).
The Hausman specification test indicates that FE is rejected in favor of the RE
in Eq. 7 of SGR, and in Eqs. (8) and (9), RE is rejected in favor of FE. The results
presented in Table 10 show that STDL and LTDL are positively related to SGR, but
the relationship is highly insignificant. TLEVR is significantly negatively ( − 1.184,
13
p < 5%) linked to SGR. Additionally, firm age, GDP, and INF are positively related
to SGR, while FDI is negatively related to SGR. In Eq. 7 of Tobin’s Q, the Hausman
specification test indicates that RE is rejected in favor of FE, while in Eqs. 8 and 9,
FE is rejected in favor of RE. The results show that STDL, LTDL, and TLEVR are
significantly negatively related to Tobin’s Q. Additionally, firm size, liquidity, and
INF are significantly negatively linked to Tobin’s Q, while Risk, NDTS, and FDI
are significantly positively linked. In Eqs. (7)–(9) of ROA, the Hausman specifica-
tion test indicates that RE is rejected in favor of FE. The results show that all three
measures of financial leverage (i.e., STDL, LDTL, and TLEVR) are significantly
negatively associated with ROA. Additionally, liquidity and NDTS are significantly
negatively related, while risk and firm age are positively related to ROA. In the case
of ROE, the Hausman specification test indicates that FE is rejected in favor of RE
in Eqs. 7–9. The results show that all three measures of financial leverage are nega-
tively related to ROE, but the relationship between TLEVR and ROE is negative
but insignificant. Additionally, GDP and FDI are significantly negatively related
to ROE, while firm size and INF are significantly positively related. In the case of
ROS, the Hausman specification test indicates that the FE model is appropriate for
Eqs. (7)–(9). The results show that all three measures of leverage are significantly
negatively associated with ROS. Additionally, liquidity is significantly negatively
correlated with ROS, while firm size and risk are significantly positively correlated
with ROS.
Overall, the results found using the FE and RE methods are somehow consistent
with the GMM results. Some differences between the results of the dynamic and
static regressions could be because of the existence of endogeneity, serial correla-
tion, persistent performance, and unobserved heterogeneity. Therefore, the use of
dynamic regression (i.e., two-step GMM system estimator) addresses these four
main problems and produces corrected and consistent inferences. Thus, GMM is
proven to be the most reliable and valid method.
6 Conclusion and discussion
This study investigated how financial leverage influences the firm performance of
Pakistani listed companies. For this purpose, unbalanced dynamic panel data on
424 nonfinancial Pakistani companies listed on the PSX over the seventeen-year
period from 2001 to 2017 were taken from audited financial statements and the SBP.
The results of this study are based on the generalized method of moments (GMM),
which addresses endogeneity, performance persistence, serial correlation, and unob-
served heterogeneity and produces unbiased and consistent results. The perfor-
mance of Pakistani listed companies was measured using SGR, Tobin’s Q, ROA,
ROE, and ROS. To ensure robust findings, financial leverage was categorized into
STDL, LTDL, and TLEVR. Furthermore, the impact of company-specific variables
(FSIZE, RISK, LIQ, FAGE, NDTS, FOWN, and GOWN) and macroeconomic vari-
ables (GDP, FDI, and INF) was also controlled to determine unbiased findings. The
results reported a negative association among all measures of financial leverage and
performance, i.e., STDL was found to be significantly negatively associated with
13
SGR, Tobin’s Q, ROA, ROE, and ROS; LTDL was found to be significantly nega-
tively associated with SGR, ROA, ROE, and ROS; and TLEVR was found to be sig-
nificantly negatively associated with all performance measures, i.e., SGR, Tobin’s
Q, ROA, ROE, and ROS. Additionally, the results revealed an inverted U-shaped
relationship between STDL, LTDL, and TLEVR with performance when meas-
ured by SGR, Tobin’s Q, and ROA. It showed a positive effect of financial leverage
on performance up to a certain extent; however, after hitting a particular level, the
positive association between financial leverage and performance becomes negative
because of financial distress and bankruptcy costs. Furthermore, the results indi-
cated that RISK, GOWN, FOWN, GDP, and FDI positively influence performance,
while FSIZE, LIQ, FAGE, NDTS, and INF negatively influence performance.
This study is likely to be useful for academics, management, policymakers,
and regulators, as it has some important policy implications. As shown in the
summary statistics, the STDL accounts for most of the total leverage of Paki-
stani listed companies; in emerging countries, this is a common occurrence.
Specifically, the mean ratio of STDL is 49.9%, while the mean ratio of LTDL is
only 17.8%. Moreover, as specified before, Pakistani listed firms heavily rely on
STDL because they suffer from information asymmetry, whereas their reliance
on LTDL is minimal. In the meantime, STDL negatively affects performance
because it pushes firms to face the risk of refinancing (Dalci 2018; Le and Phan
2017). Hence, the higher use of STDL is the main cause of the negative asso-
ciation between financial leverage and firm performance. Therefore, companies
with a lower LTDL ratio make a lower level of long-term investments and thus
earn low profits in the future. Although both STDL and LTDL have a negative
effect on performance, a high magnitude of STDL reduces the performance of
Pakistani listed companies. Therefore, to improve financial sustainability, we sug-
gest that companies prefer LTDL to STDL (Zhang and Chen 2017). Furthermore,
due to the weak institutional environment in Pakistan, agency conflicts between
managers and shareholders may arise; thus, the negative effect of financial lever-
age on firm performance might also result from agency problems and information
asymmetry. Therefore, companies in Pakistan should also keep in mind that after
reaching a particular level of debt, they are likely to face the risks of bankruptcy
and financial distress. However, based on these findings, it is suggested that an
optimal amount of financial leverage is essential to raise the performance of
Pakistani listed companies. However, our study found that Pakistani nonfinancial
listed companies are already overleveraged; therefore, all measures of financial
leverage have a negative impact on performance. The future scope of this study
can be derived through several implications. First, the managers of Pakistani non-
financial listed companies should benefit from the tax shield of external financial
leverage. However, after a particular level of financial leverage is reached, they
should also keep in mind the risk of financial distress and bankruptcy that they
are likely to face. Therefore, for managers using a moderate level of financial lev-
erage in capital structures, finding an optimal capital structure is an important
issue. Second, the Pakistani government should direct its efforts toward promoting
alternative privately owned loan creditors to state-owned banks and developing
bond markets. In this way, nonfinancial listed companies in Pakistan, through the
13
issuance of bonds in the capital markets, will be able to raise long-term financial
leverage and will be less dependent on expensive short-term financial leverage.
As a result, companies will not miss long-term investment opportunities, and they
will eliminate the risk of refinancing. Additionally, the agency conflicts between
shareholders, creditors, and managers will also be mitigated due to the develop-
ment of the bond market. Therefore, superior firm performance is achieved by
creditors and shareholders exercising remarkable pressure on company managers.
Third, managers of Pakistani nonfinancial listed companies should try to increase
the level of LTDL and reduce the STDL in their capital structures with the devel-
opment of capital markets and the privatization of credit institutions. The findings
of this study help us to understand optimal capital structure issues, especially for
Pakistani nonfinancial listed companies. Finally, in this study, a nonlinear rela-
tionship between financial leverage and firm performance was observed, which
is somewhat novel, indicating that only an optimum level of financial leverage is
beneficial for achieving enhanced performance.
Although our study offers interesting findings, it has certain limitations. First,
it focuses on Pakistani nonfinancial listed companies. Therefore, future studies
should focus on the financial leverage of Pakistani financial companies to see
whether the results can be generalized. Second, the corporate governance of Paki-
stani listed companies is not taken into account in the current study. Therefore,
how corporate governance influences the financial leverage and performance of
firms in Pakistan can be investigated in future studies. The current study finds
that financial leverage negatively impacts the performance of Pakistani listed
companies. Thus, a similar study can be replicated in other developing and devel-
oped countries that remain unstudied.
Acknowledgements The authors would like to thank the anonymous referees very much for their valu-
able comments and suggestions. This work would not have been possible without their support. We are
also thankful to the editorial board for considering our work for the publication. This work was supported
by the National Natural Science Foundation of China No. 71973054.
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Economic Change and Restructuring

Impact of financial leverage on sustainable growth, market

Muhammad Akhtar1 · Kong Yusheng1 · Muhammad Haris1,2 · Qurat Ul Ain3 ·

Received: 25 December 2019 / Accepted: 21 January 2021

Keywords Financial leverage · SGR · Tobin’s Q · ROA · ROE · ROS · GMM ·

JEL Classification C23 · G32 · G33 · L25

The understanding of financial leverage assists companies in assessing their finan-

2 Overview of firms in Pakistan

5553 billion rupees in 2007 to 12,417 billion rupees in 2017 (http://​finan​ce.​gov.​pk/),

3.2.1 Firms from Pakistan

found a negative impact of all measures of financial leverage (i.e., short-term

3.2.2 Negative impact of financial leverage on firm performance

3.2.3 Positive impact of financial leverage on firm performance

3.2.4 Nonlinear relationship between financial leverage and firm performance

H1 There is a significant relationship between financial leverage and the perfor-

between financial leverage and firm performance in other economies. Specifically,

H2 There is a nonlinear (inverted U-shaped) relationship between financial leverage

4 Data and methodology

4.1 Sample and data

Table 1 List of samples

1 Textile 161 2295

1.2*(working capital/total assets) + 1.4*(retained earnings/total assets) + 3.3*(earn-

4.2.2 Analysis approach and methodology

However, the problems of possible heteroskedasticity and autocorrelation can be

Table 3 Unit root test Company-specific variables Macroeconomic variables

SGR 3027.475 0.000 GDP 1340.529 0.000

SGR 6085 0.677 21.267 − 366.018 1395.198

This study observed an association between financial leverage and performance by

5.3.1 Impact of financial leverage on performance

The outcomes regarding the impact of financial leverage on the performance of

(0.198) (0.608) (0.112) (0.227) (0.289)

(2.938) (5.677) (0.035)

(1.303) (20.900) (0.074) (0.199)

STDL 0.268 − 1.219*** − 0.073*** − 0.006*** − 2.189***

TLEVR − 1.184** − 1.322*** − 0.084*** − 0.026 − 1.203**

companies is exacerbated. Previously, Zhang and Chen (2017), Vithessonthi and

5.3.2 Inverted U‑shaped relationship between financial leverage and firm

indicates that similar to STDL, an increase in LTDL increases the performance of

5.3.3 Robustness check (change in dependent variables)

To ensure the robustness of our study, we conducted an additional test by replac-

5.3.4 Robustness check (change of methodology)

6 Conclusion and discussion

You might also like

2 Overview of firms in Pakistan

5553 billion rupees in 2007 to 12,417 billion rupees in 2017 (http://finance.gov.pk/),

3.2.1 Firms from Pakistan

3.2.2 Negative impact of financial leverage on firm performance

3.2.3 Positive impact of financial leverage on firm performance

3.2.4 Nonlinear relationship between financial leverage and firm performance

4 Data and methodology

4.1 Sample and data

1.2(working capital/total assets) + 1.4(retained earnings/total assets) + 3.3*(earn-

4.2.2 Analysis approach and methodology

5.3.1 Impact of financial leverage on performance

STDL 0.268 − 1.219* − 0.073* − 0.006* − 2.189*

TLEVR − 1.184 − 1.322* − 0.084* − 0.026 − 1.203

5.3.2 Inverted U‑shaped relationship between financial leverage and firm

5.3.3 Robustness check (change in dependent variables)

5.3.4 Robustness check (change of methodology)

6 Conclusion and discussion