Financial Performance Implications of Capital Structure Choices: Evidence from Listed Non-Financial Companies in Sri Lanka

Capital structure decisions are considered as critical in the present highly competitive financial world, as firms strategically adopt them to accomplish their goals. The composition of a firm’s capital influences its overall cost of financing and value. Particularly, firms need to cautiously evaluate the advantages of debt financing in contrast to the potential costs of insolvency and financial distress. The primary objective of the study is to examine the extent to which capital structure choices influence the financial performance of non-financial companies in Sri Lanka. This study includes the independent variables of the Debt-to-Equity Ratio and Debt to-Total Assets Ratio, reflecting the proportion of debt and equity used to finance operations and growth and the dependent variables are Return on Equity (ROE) and Return on Assets (ROA), which measure financial performance. Under the stratified random sampling method 70 non-financial companies were selected and the relevant data of the sample companies were collected for the period from 2020 to 2024 from the audited annual financial statements of the companies. The statistical techniques of Pearson’s correlation and panel data regression were used to analyse the association between the capital structure decisions and the financial performance. The findings of this study reveal that Debt-to-Total Assets Ratio has a significant negative impact on ROA of listed non-financial companies in Sri Lanka, which indicates that beyond a certain threshold, leverage does not improve performance but instead limits profitability. This finding supports the view that maintaining an optimal capital structure is a prerequisite for achieving operational efficiency and long-term financial stability. Furthermore, the study concludes that Debt-to-Total Assets Ratio and Debt-to-Equity Ratio have significant negative impact on ROE of listed non-financial companies in Sri Lanka which suggests that beyond a certain threshold, leverage does not generate value for shareholders but instead reduces equity returns, highlighting the importance of maintaining a balanced and sustainable capital structure. Based on the findings of the study, it is recommended that firms should implement a strategically balanced financing policy to improve operational performance of the firms. Firms should maintain an optimum capital structure by restricting excessive dependence on debt and whenever possible it is advantageous to provide more emphasis to internally generated funds. Moreover, companies should adopt proper financial risk management practices to match the maturity structure of debt with asset life cycles to prevent potential liquidity pressures. This study offers broad and comprehensive practical implications that are highly valuable for policymakers.