**2. Literature Review**

Numerous theories have been developed following the initial development of capital structure theory by Modigliani and Miller (1958). These theories were later classified by their assumptions about how they a ffect firm value in the financial market. The first of these theories is the Trade-o ff theory of capital structure. This theory precedes some initial refinements in 1963 (Modigliani and Miller 1963) of Modigliani and Miller's (1958) initial work, in which taxes are added to theorize the effect of taxes on a firm's tax payable amount, increase in after tax income and its market value. This development was later labelled as trade-o ff theory, a theory which states that a firm's optimal leverage is achieved by minimizing taxes, costs of financial distress and agency costs. Baxter (1967) argued that increased debt levels increases the chances of bankruptcy and increases interest payable to the debtholders. A firm's optimal leverage is where tax advantage from debt exactly equals the cost of debt. Kraus and Litzenberger (1973) argue that a firm's market value declines if its debt obligations are greater than its earnings. DeAngelo and Masulis (1980) propose the static trade o ff theory and include other tax minimizing o ffsets such as depreciation and investment tax credits. They argue that firms weigh tax advantages of debt against business risk (a cost). Their theoretical model proposes that a firm's optimum debt level is where the present value of tax savings from debt equals the present value of costs of distress.

Myers (1984), in his theoretical explanation of the asymmetric information hypothesis, proposes di fferent information held by firms' internal and external stakeholders. Managers hold real information about firms' income distribution plans (Ross 1977). Thus, firm's leverage level signals its confidence levels, suggesting lower leverage as a poor signal about income and its distribution potential and vice versa. Pettit and Singer (1985) discuss the problems of asymmetric information and possible agency costs a ffecting firms' demand and supply of credit. They argue that small firms possess a higher level of asymmetric information due to financial constraints for su fficient disclosure of financial information to outsiders. This theory has laid the foundation for Pecking Order Theory (POT). Donaldson (1984) proposes the concepts and ideas of Pecking Order Theory (POT) which was later refined by Myers (1984) and Myers and Majluf (1984). The fundamental premise of this theory is that firms' preferences for funding is stacked by a pecking order of risk preferences and corresponding costs. Thus, firms use the cheapest source of internal funds such as retained earnings, debt, convertible debt and preference shares) and external equity (Myers 1984). The cost of sourcing extra funding is dependent on the extent of information asymmetries of risk perceptions emanating from di fferential information needs held by inside managemen<sup>t</sup> and potential investors. In addition to a firm's desire to source the cheapest fund to finance its needs, other factors, such as the stage of development of a firm (a startup, a mature firm etc.) influence the supply of funds (Macan Bhaird and Lucey 2010).

Agency theory (Jensen and Meckling 1976) addresses the fundamental problem of managing a firm's capital structure from the cheapest source of funds. While common equity is an expensive source of funds, its use results in suboptimal firm value when equity holders insist on risk reduction from lower leverage usage. If managers' and shareholders' interests are not aligned, it is highly unlikely that optimal firm value is ever going to eventuate from managerial actions. The debtholders' risk perceptions encourage them to ask for debt covenants or other costly debt shielding instruments. The tensions between the two subgroups of owners impose increased risk of monitoring by management, resulting in costly monitoring and hence, agency costs. A number of remedial measures can be implemented such as reduction in consumption of resources when debt and bankruptcy risks increase (Grossman and Hart 1982), increasing the stake of managers in a firm or increasing the leverage (Jensen 1986), commonly packed as 'free cash flow hypothesis'. Free cash flow hypothesis proposes adoption of measures to reduce free cash flow at managers' disposal by increasing leverage (Stulz 1990) so that less cash flow is available for desired investment choices.

The theories above are prevalent in different country specific studies. An empirical study by El-Sayed Ebaid (2009) on Egyptian firms sugges<sup>t</sup> a negative relationship between profitability and shorter-term or total debt when return on asset is used to measure profitability. The results also sugges<sup>t</sup> no significant relationship between short-term or long-term debt and profitability when return on equity or gross margin is used as a measure of profitability. Salim and Yadav's (2012) study on 237 listed Malaysian companies from 1995–2001 found a negative relationship between short-term and long-term debts and all measures of profitability, return on assets, return on equity and earnings per share. Ahmed Sheikh and Wang (2011) examined 240 listed Pakistani non-financial companies during the 2004–2009 period. Three statistical tests, fixed effects, random effects and ordinary least squares found negative relationships between debt and return on assets. Weill (2008) used the maximum likelihood estimation method to analyze the effect of financial leverage on the performance of 11,836 firms from seven European countries over a three-year time period, 1998–2000. The results indicate that the long-term debt ratio is positively related at statistically significant level in Spain and Italy but negatively related at statistically significant level in Germany, France, Belgium and Norway, and insignificantly in Portugal. Goddard et al. (2005) used the generalized methods of moments system to test the determinants of profitability of manufacturing and service firms in Belgium, France, Italy and the U.K. from 1993–2001. They found a negative relationship between the sample firms' gearing ratio and profitability, and higher profitability in more liquid firms. Abor (2007) used a generalized least squares regression to study a sample of 160 Ghanaian and 200 South African Small and Medium Enterprises (SMEs) from 1998–2003 and found a negative relationship between longer-term and total debt ratios and profitability. Yazdanfar and Öhman's (2015) study used 15,897 Swedish SMEs from five different sectors from 2009–2012 to examine the effect of three different forms of debt ratios, trade credit, short-term debt and long-term debt on profitability. The results sugges<sup>t</sup> a negative relationship between all types of debts and profitability, suggesting an increased use of equity capital to finance Swedish SMEs.

There are not many Australian studies on the relationship between capital structure and profitability. Li and Stathis (2017) examined the determinants of the capital structure of Australian manufacturing listed traded firms. The study used eight factors: profitability, log of assets, median industry leverage, industry growth, market-to-book ratio, tangibility, capital expenditure and investment tax credits. They found weak support for the pecking order hypothesis and increasing support for the trade-off theory in Australia. Qiu and La (2010) examined the relationship between firm characteristics and capital structure of 367 Australian firms over a 15 year period. Their study identified the role of debt on profitability, tangibility, growth prospects and risk of these firms. They concluded that profitability has the potential to reduce debt levels of Australian firms, implying debt reduction through increased profits was possible in Australian firms. Barth et al. (2001) examined the relationship between capital structure and profitability of 107 countries including Australia. They tested for regulatory power, supervision, and other factors affecting the relationship between profitability and leverage across the countries studied. Rashid and Islam (2009) examined 60 companies in the Australian Financial services sector during the years 2002–2003. The results sugges<sup>t</sup> that profitability is negatively affected by leverage, and positively a ffected by board size, liquid markets and information e fficiency (all control variables).

Firm performance as a measure of the impact of di fferent proxies for capital structure has added new insights in recent times. Some country-specific studies have examined the direct e ffect of using di fferent types of debts on firm performance. Most of these studies reported a significant negative relationship between debts and firm performance. Chakrabarti and Chakrabarti (2019) examined firm-specific and macro-economic variables on 18 Indian non-insurance firms for seven years. They found a positive relationship between low insurance, low input costs, low inflation rates, higher return on investment, liquidity and profitability. Dalci (2018) examined the impact of capital structure on 1503 listed manufacturing firms in the Chinese stock exchange between the years 2008–2016. They found an inverted U-shaped relationship between capital structure and profitability and provided the causes of a negative and positive relationship between financial leverage (as a measure of capital structure) and profitability. This is a major study that highlighted the importance of the developments of credit market policies and rules for the advancement of di fferent-sized Chinese manufacturing firms.

Dave et al. (2019) examined the impact of capital structure and profitability of firms in the Indian Steel industry and observed a significant negative relationship between long-term and short-term debts as a ratio of total assets and profitability. Helmy et al. (2020) examined the impact of capital structure, internal governance mechanism, and firm-performance of 183 Bursa-listed Malaysian companies for the years 2007–2010. They found a positive impact of capital structure on firm performance. Gharaibeh and Bani Khaled (2020) examined the factors that played key roles in the profitability of 46 Jordanian service sector companies between the years 2014–2018. They found that debt as a portion of total assets and tangible assets have significantly negative relationships with profitability whereas tangible size and business risk had a positive relationship with profitability.

Hussein et al. (2019) examined listed Jordanian firms between 2005–2017. Using three measures of firm performance, return on assets, Tobin's Q and return on assets, and total and short-term debt as a proxy for capital structure, they observed a positively significant relationship between firm size, asset growth, significant negative relationship between short-term debt and long-term debt and return on assets. However, they did not find any significant negative relationship between short-term and long-term debts and return on equity measure of firm performance. Lastly, Yazdanfar examined 15,897 firms working in five SME sectors of the Swedish economy between 2009–2012. They found debt ratios (trade-credit, short-term and long-term debts) negatively a ffected firm profitability.

Capital structure studies that examined the relationship between di fferent proxies for capital structure and firm performance used a variety of measures to define profitability. Some studies used a single measure (see, for example, Arifin 2017; Negasa 2016) while others used multiple measures such as return on Equity (ROE), return on assets (ROA), and return on capital invested (ROCE) (see, for example, Gharaibeh and Bani Khaled 2020; Musah and Kong 2019). In these studies, di fferent types of debts are used as proxies for capital structure and di fferent control variables are used to measure the collective impacts on firm performance. The relationship between firm performance and capital structure is assumed to be unidirectional in most of the studies reviewed above. However, some recent studies validated the causal relationship between capital structure and firm performance (Arifin 2017; M'ng et al. 2017). Finally, the studies above showed a negative, positive, and mixed relationship between capital structure measures and firm performance.

The studies are from diverse sectors and cover a wide range of firm year cross sectional observations. There is a limited number of studies that examine the linkage between di fferent measures of firm performance (or profitability) and capital structure. Studies covering the services sector are hardly noteworthy in the Australian and global contexts. Moreover, the directional causal relationship between di fferent types of borrowings and firm performance is hardly examined in detail in the studies reviewed above. This study contributes to the growing body of literature in the study of capital structure in the under-researched domains of service sector firms in Australia and internationally.
