Analysis of capital structure and its effects on profitability: Evidence from financial service companies in the UK

London, the capital of the United Kingdom (UK) is one of the leading financial hubs in theworld and it is also known as the financial capital of Europe. In the UK, the majorcontributors to the UK’s economy are the financial service companies (FSCs). However,FSCs in the UK have been critically affected by 2008-2009 global financial crisis. Besides,financial service companies faced a tough competition from FinTech industry sector. In thisregard, profitability is regarded as one of the most important measurements of the success ofFSCs in the UK. To cope with these challenges, acquiring more funds and deciding whetherto rely on debt funds or equity funds has become a major issue. This study aims to study thecapital structure and its effect on the profitability of the FSCs in the UK.To build the foundation, this study builds the conceptual framework based on empiricalstudies from different industries and countries. The conceptual framework has helped thisstudy to draw three different objectives, which are factors that influence the capital structuredecision, relation between capital structure and profitability of the firm and the effect ofcapital structure on profitability of FSCs in the UK.This study focuses on the financial service companies listed on the London Stock Exchange(LSE) from the period of 1998 to 2018. Data is collected from secondary sources such asannual reports of the sixty financial service Companies. The number of observations in thisstudy is 1260. In this study, Pearson correlation and regression analysis have been deployedthat makes this study a quantitative research with positivist philosophy and deductiveapproach. The results of this study show that external factors such as inflation and interest rate have animpact on capital structure and profitability. Inflation has a positive impact on short-term debtand interest rate has a positive impact on long-term debt, total debt and debt to equity ratio. Inaddition, short-term debt is influenced by total assets and liquidity. On the other hand, long-term debt is influenced by total assets, firm age, earning per share, and effective tax rate. In regard to the profitability, capital structure shows an impact on firm’s profitability. Shortterm debt and long-term debt have a negative effect on ROA and ROIC. In case of externalfactors, financial crisis has a negative effect on ROA and ROIC whereas inflation shows apositive effect. Besides, assets growth and earnings per share both show positive effect onROA and ROIC. Furthermore, ROE and ROCE both negatively affect short-term debts and ispositively affected by debt to equity ratio. Similar to RAO and ROIC, inflation has a positiveeffect and financial crisis shows a negative effect. Both assets growth and earnings per shareshow positive influence.This study extends the previous study of Abor (2005) by supporting that debt has a negativeimpact on profitability. Further, it also widens the study of Nasimi (2016) by including morevariables in the study. In addition, this study supports the findings of Abeywardhana (2016)where the results show that the smaller firms are less dependent on debt funds and the largerfirms maintain higher debt level in the capital structure. This study provides a new argumentto the study of Gill et al. (2011) where debts have a negative effect on the profitability offirms rather than the positive relation. In addition, this study challenges the study of Vuong etal. (2017) by showing that financial crisis has a negative impact on firms’ profitability in theUK’s market. On the other hand, this study contradicts with the findings of Bui (2017) byshowing negative effect of debt on firms’ profitability.The present study recommends financial service companies in the UK to follow the trend ofinterest rate and inflation rate in order to reduce agency cost and maximise tax shield. Inaddition, this study recommends the financial service companies to increase debt borrowingsand balance the equity financing. This research also provides guidance for future research toexplore this study in qualitative method with primary data. In addition, it recommendsexploration of more areas and extension of time period.