The Relationship Between Leverage and Firm Performance Introduction

Abstract

This study investigates the relationship between financial leverage and firm performance by employing a mixed-methods approach that integrates econometric panel data analysis with qualitative managerial insights. Using firm-level data spanning, firm performance was assessed through Return on Assets (ROA), Return on Equity (ROE), and Tobin’s Q, while leverage was measured as the debt-to-asset ratio. The econometric models—including fixed effects, random effects, and generalized method of moments estimators—consistently revealed negative and statistically significant coefficients for leverage, indicating that higher debt ratios diminish firm performance. Quintile analysis further demonstrated that profitability declines systematically across higher leverage categories, suggesting a threshold beyond which debt becomes detrimental. Complementary qualitative evidence from semi-structured interviews with financial managers and auditors reinforced these findings, highlighting risk aversion, governance challenges, and market volatility as key determinants of capital structure effectiveness. Collectively, the results align with the trade-off theory by emphasizing the need to balance tax benefits of debt against financial distress costs, while also reflecting pecking order dynamics in contexts where internal financing is prioritized. The study concludes that while moderate leverage can be beneficial, excessive reliance on debt reduces firm efficiency and profitability, particularly for smaller firms in emerging markets. These findings carry significant implications for corporate managers, investors, and policymakers, underlining the importance of context-specific and size-adjusted financing strategies to ensure sustainable firm growth.