2.1. Theoretical Framework
Capital structure hypothesis initially started at the end of 1950s; the first theory was the irrelevance theory developed by [8], well known as the Modigliani–Miller (MM) theory. According to this concept, there is no ideal capital structure for companies [9,12]. After some revision, Modigliani and Miller proposed a trade-off model based on no tax assumptions [12]. According to [25], the trade-off theory argues that companies accept debt over equity when the benefit of debt, through a reduction in interest expenses prior to calculating income tax, is greater than the marginal cost of the debt. In other words, corporations possess a special optimum capital structure that compares the tax benefits of financing through debt with the costs of debt [9,26,27,28]. Firms that rely on debt financing have a greater value than companies that do not use debt [6,12]. However, debt should be utilized completely; otherwise, paying interest rates may become a burden for the firm.
On the other hand, the pecking order theory can be seen as the most popular hypothesis of capital structure that clarifies how capital structure, firm performance, and profitability are related to each other. This theory was developed by [14] and claims that firms should use a hierarchy in obtaining their source of financing to cover their capital requirements and improve their profitability [26,29], and this is also an effective strategy to reduce the issues of information asymmetry as well [30]. This theory recommends that firms should use retained earnings first because they hold a lower risk. However, when internal financing is not sufficient, firms turn to less risky debt to prevent missing potential investments. As a last option, when they are unable to acquire debt, firms can issue new stocks or equity instead [4,9,12,13,25,26,31].
Ref. [32] investigated the relationship between debt financing and firm value by adopting both pecking-order and trade-off methodologies for Taiwanese listed firms based on 2548 observations. The findings illustrated that when the ratio of debt is lower than 10%, firm value rises by 0.05%, with a 1% rise in the debt ratio. Additionally, when the ratio of debt is in a range between 10% and 33%, firm value is improved only by 0.005% with a 1% rise in the debt ratio. These results are completely evidenced by the trade-off theory, which argues that firms have a static amount of loan that encourages managers to seek the ideal capital structure. Thus, firm value increases when the benefit of debt financing is comparable to the marginal debt expenses.
Ref. [33] evaluates the role of pecking order theory on explaining the behavior of leverage in Pakistani listed firms. The study used 34 years of uniformed financial data for manufacturing firms. The results show that both recent and previous profitability are negatively impacted by leverage, while past dividends are positively affected by leverage. Similarly, ref. [27] examined the conclusive evidence on the pecking order and trade-off theory of capital structure. The study covered non-financial listed firms on the Indonesia Stock Exchange (IDX) during 2014–2017. The findings illustrated that the firms focus on financing decisions depending on their financial health. Firms with both lower and higher levels of leverage who face financial deficiencies frequently raise their amount of debt. Alternatively, corporations with financial surplus prefer to raise their power, regardless of how much debt they have. These findings are strongly supported by the pecking order theory which claims that firms should use internal sources first, such as “retaining earnings”; then, debt must be adopted by firms, and when the debt is not accessible by the firm, equity can be released as a last report.
2.2. Empirical Evidence and Hypotheses Development
Numerous academic studies have examined the potential connection among firm size, capital structure, and firm value in various economic or business industries, such as non-financial firms [6,34]; manufacturing firms [35]; the mining industry [4]; the pharmaceutical sector [36]; the construction and property industry [37]; the banking sector [21]; and listed firms on the stock exchange [3,16,25].
2.2.1. Capital Structure and Profitability
As the current research seeks to objectively explore the connection between firm size, capital structure, and profitability, our review of the literature will concentrate on work in this field. It is commonly believed that in the actual world, where markets are not perfect, capital structure has a significant influence on firm profitability or firm performance, and theoretically, this is proven by many hypotheses in the literature [34]. However, previous investigations provide a variety of findings about this connection. According to [38], the exact relationship between financing choices and firm profitability may vary depending on the conditions. We found that the nature of the association between capital structure decisions and profitability and performance tend to be influenced by certain circumstances, such as the size of the firm, the economic condition, and the country’s level of development.
In this context, numerous studies demonstrate that capital structure influences firm performance favorably in developed countries that have established strong financial or economic systems [38,39]. However, other investigations have reported a negative relationship between capital structure decisions and profitability in developing countries [1,3,17,18,31,40]. These results are supported by the pecking order theory which claims that highly productive firms do not rely heavily on external financing.
Further, using balanced panel data of several manufacturing firms listed on the Iraqi stock exchange in the 2004–2020 period, ref. [12] empirically tested the correlation between capital structure and finance performance that is measured using return on assets (ROA) and market-to-book value (MBV). They found that ROA and MBV are inversely impacted by leverage. Likewise, ref. [41] examined a similar industry based on the number of manufacturing firms listed on the Indonesia Stock Exchange over the years 2008–2015 and showed that there is a strong and negative relationship between capital structure and firm profitability. In other industries, such as banks, refs. [42,43] reported a negative and significant relationship between capital structure and firm performance, while [44,45] found a positive relationship. Other studies indicated a non-linear association, meaning that both negative and positive connections were found [34,46,47,48], and some other investigations found a non-significant relationship [49,50]. Thus, the following hypothesis is proposed:
Hypothesis 1. Profitability is significantly affected by capital structure.
2.2.2. Firm Size, Capital Structure, and Profitability
Despite the extensive testing of the association between capital structure and profitability, firm size as a moderator is expected to have a significant contribution to this relationship. Previous investigations indicated that multiple market values are caused by different firm sizes [3,51,52,53,54,55,56,57]. In addition, refs. [3,51,52,56,58,59] found that firm size has a positive and considerable influence on profitability. Further, [53] illustrated that small companies are more capable than big companies to evaluate their value. However, ref. [4] demonstrated an adverse connection. Others, such as [54], reported mixed findings, and no indicative association was found by [55].
In addition, a few studies have examined the moderating effect of firm size on the relationship between capital structure and financial performance. Ref. [60] conducted a study on non-linear associations among the size of the firm, capital structure, and profitability. The study used a huge sample of 1194 companies in the Indian industrial sector, which is publicly traded. The period considered was 2005 to 2014. The findings clearly indicated that the impact of the capital structure on firm profitability can be determined by the size of the firm. Likewise, ref. [6] examined the sensitivity of firm size to the relationship between financing decisions and the value of the firm. The study utilized the market values and financial statements of 1638 firms listed on the Indonesian stock exchange over the period 2012–2018. The results showed that the size of a company influences the effect of capital structure decisions on the company’s value. The extensive theory and empirical evidence from prior investigations that are related to the relationship between the size of the firm and financing choices, and between the firm size and profitability, illustrate that firm size is a reliable factor for determining capital structure decisions and profitability [3,6,51,52,56,58,59,60,61]. Firm size can be seen as a crucial component of capital structure due to its ability to serve as an indicator of a company’s sustainability, and it also justifies additional studies into how company size affects the connection between financing choice, profitability, and market value [6]. Based on the above arguments, we propose the second hypothesis as follows:
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