Impact of Corporate Governance Quality on Financing Decisions and Profitability

Quratulain Akhtar

Impact of Corporate Governance Quality on Financing Decisions and Profitability

Introduction

Corporate governance quality is concerned with the relationship between businesses management and its board of directors, shareholders and lenders and its other stakeholders such as employees, customers, suppliers, and the community in which activates. Corporate Governance quality is the mode through which entities are managed and governed.

        The word “corporate governance quality” implies the management decisions taken that would create an impact on the firm overall performance (Rehman & Hussain, 2013). Corporate governance quality influences the efficiency of firm production at the corporate level, so that the effectiveness of a nation’s corporate governance system shapes economic performance at a country level.

`Corporate Governance quality has significant impact on financing decisions of firm. Based on agency theory, the importance of Corporate Governance quality is to reduce agency conflicts between those who control and those who own the residual claims in a firm. In other words, Corporate Governance quality as a mechanism helps to align management's goals with those of the stakeholders and hence to increase firm profitability (Chaghadari, 2011).

        High quality corporate governance plays a significant role in influencing a firm’s choice of debt versus equity financing. With poor corporate governance quality there is information asymmetry (agency problem) between owners and managers. Investing in a firm with high quality corporate governance provides a significant solution for many agency problems. With high quality corporate governance investors believe that quality of financial reporting system is high. According to previous research investors are more willing to provide financing to firms with high quality governance.

Corporate governance quality can reduce information asymmetry problems facing some firms to a level where equity becomes more desirable to debt. With high quality corporate governance when there is less agency cost firm is more willing to choose equity financing as compared to debt financing.

Corporate governance quality was measured with board size and audit committee.  Previous studies found that small board are associated with high quality corporate governance. As board size increases communication problem increases (Mande, Park and Son, 2012).  Large audit committee size exhibits the high quality corporate governance.  When more members of the board are involved in monitoring the financial reporting process of the firm, we expect the quality of the governance to increase. With the previous research following hypothesis formulated, firms with high quality corporate governance are more likely to issue equity than debt financing and with the high quality corporate governance firm profitability increases. By using the multiple regression analysis technique we found that both the independent variables were positively related with firm equity financing policy. With high quality corporate governance firm choose equity financing policy. Researchers also found the significant impact of corporate governance quality (board size) on firm profitability (return on equity), however relationship between audit committee size and firm profitability was insignificant, with poor corporate governance quality firm profitability decrease. Larger firms which are viewed as less risky are able to and tend to issue more debt than equity, researcher kept the impact of firm size (total asset) constant. Further research shed light on the importance of different variables of corporate governance quality like( CEO duality and ownership concentration) and its impact on firm profitability and firm choice of financing policy can be consider.

Literature Review:

                Corporate Governance quality has important implication on financing decision. In the study “The effect of corporate governance quality and ownership structure on capital structure of Iranian listed companies” Researchers used the sample of 42 listed companies in Tehran stock exchange.  Multivariate regression technique was used in this study.  The authors measured the corporate governance quality with board size, CEO duality and profitability was measured with return on asset.  Capital structure was measured with book value and market value.  The results found the positive relation between CEO duality and firm profitability (Bodaghi & Ahmadapour, 2010).  

Mousavi ,Jari  and Aliahmadi (2012) in their study “The evaluation of corporate governance quality a monitoring  mechanisms on capital structure in Tehran Stock Exchange” found that  corporate governance quality mechanisms(board of direction size, institutional ownership, and ownership concentration) had significant impact on capital structure of firm.  Researchers investigated this relationship in Tehran stock exchange. The sample of 90 companies from manufacturing industries was used.  They found the significant impact of corporate governance quality on firm capital structure.

Najjar and Hussainey(2010) in their study “What drives firms’ capital structure and dividend policy” evaluated the relationship between corporate governance quality and firm capital structure .Researchers took the sample of 379 firms from UK. Results were investigated with effect panel models and random effect Tobit models. Ordinary least square method was used to analyze the relation between dependent (debt, equity) and independent variables (board size, outside directorships.  The results suggested the positive effect of corporate governance quality drivers (board size and outside directorships) on capital structure decision of the firm

Williamson (2000) in their study “Corporate finance and corporate governance quality” investigated the relationship between corporate governance quality and capital structure.  The sample of 102 companies and banks and insurance companies were selected as a sample. Tobin’s q analysis was used to analyze the relation between dependent and independent variables. Corporate governance quality was measured with board size, ownership concentration, and board independence. The study found that corporate governance quality had significant influence on financing policy of firm.