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The analysis of the Saudi Arabian companies, with respect to their capital structure follows a
standard format. Firstly, the emphasis was on the hypothesis development based on literature
review (theoretical review), after that meta analysis was done which is basically the prior
empirical research studies, and lastly the research methods were determined and research was

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conducted to support the results and come up with latest reviews.

Literature Review

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Over the past decades, research on different topics of finance has been conducted and different

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theories have taken form, all of them try to explain major factors behind financial concepts in
their own unique way. Some of the theories related to capital structure and financing policy are
discussed below:
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1. Modigliani and Miller propositions

When reviewing the theoretical literature related to capital structure, it is always beneficial to
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start with the work of Modigliani and Miller (1958). The major assumption to derive the
propositions was: capital market is perfect.
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The Proposition I (Modigliani and Miller, 1958) emphasizes on the fact that each firm has its
own capital structure and each firm’s sales, revenues, and performance, in short, are independent
of its capital structure. Because performance would be the same irrespective of the source of
funds, whether they are generated internally as equity finance or externally as debt finance.
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Therefore, there is no optimal capital structure that maximizes the value of the firm.
Consequently, this is evident from the theory provided above that in a perfect world; the value of
the levered firm is equal to the value of unlevered firm.

The Proposition II (Modigliani and Miller, 1958) emphasizes that the rate of return required by
shareholders increases with the increase of debt financing because it makes the firm more
vulnerable and risky to operate with fix payments to make each term. In another word, any



benefits from using debt would be offset by the corresponding higher cost of equity so ultimately
the value of the firm calculated with any method will be the same at any combination of debt and
equity financing.

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However, in reality, this assumption is not reliable to base a whole theory on that, because in this
real world it is impossible to have a perfect market. Issues such as taxes, financial distress,
asymmetric information, regulatory bodies and conflicts between economic agents have an effect

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on the firm’s capital structure. So one cannot rely solely on the results of this theory, work has
been done to come up with some more reliable theories.

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2. Models based on trade-off theory:

Trade off theory was presented by Myers (1984) to extend the work of M & M propositions, it
assumes that there are benefits and costs associated with the use of debt as against equity and
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firms consequently chose an optimal capital structure that trades off the marginal benefits and
costs of debt, same argument which was made clear in proposition II or M & M theory. At first,
the theory was limited to the trade off between the tax advantages of debt and the bankruptcy
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costs associated with the use of debt; then benefits and costs associated with the use of debt in
removing the conflicts among the major groups of a firm were also included in the analysis.
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The impact of tax on capital structure

In the initial form of trade off theory of capital structure, the trade off between tax advantage of
debt and the costs of financial distress are used to come up with the optimal level of debt that
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maximizes the value of the firm, but later other factors were also added to the discussion and the
theory was extended to the further level of analysis to come up with reliable results; the other
factors were related to perception, bankruptcy, and other costs.

Figure below shows a graphical representation of the theory; here the value of the firm rises as
the firm uses more debt up to a level market as optimum level of debt, where the benefits of



additional debt with the increase in the present value of tax shield are offset by the costs due to
the increased in the present value of costs of financial distress.

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Figure: The traditional static trade-off theory
Source: Myers (1984), The Capital Structure Puzzle, Journal of Finance

The first theory that inculcated the effect of tax into account was the Modigliani and Miller
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(1963) work on their previously documented propositions and took them in further details by
inculcating tax rate to that. The authors recognized that their perfect capital markets assumptions
need modifications to bring in a form that will bring out reliable results with the usage of
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corporate tax in their propositions. The main argument is: debt offers a tax shelter because
interest is deducted before taxable profit is calculated. So in the presence of corporate taxes the
value of the firm increases by an amount equal to the interest savings and the net of other relative
costs associated.
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3. Models based on asymmetric information:

Asymmetric information is another dimension of the capital structure theories; it is generally
considered that there is information gap between the management and outside investors. There
are two main approaches that have been developed in the literature of asymmetric information.
Firstly, Myers and Majluf (1984) and Myers (1984) argued that the capital structure is designed



to mitigate inefficiencies in the firm’s investment decisions that are caused by information
asymmetry. In the second approach, Ross (1977) and Leland and Pyle (1977) asserted that a
firm’s capital structure choice is used as a means to signal to outside investors the information
held by insiders.

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4. Pecking order hypothesis:

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Myers (1984), Myers and Majluf (1984) provided a theoretical findings that firms prefer to use
internally generated funds as a financing source and turn to externals funds only if the need for
funds was unavoidable and cannot be fulfilled by internal financing. The main reason is the

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floating and financing cost of the funds generated externally which make this funding more
expensive.

5. Signaling with proportion of debt:
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According to this approach, the choice to get debt from the outside sources delivers a message to
the outsiders regarding the private information of management. In this model, Ross (1977)
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assumed two types of firms (high quality with high leverage and low quality with low leverage)
that have different prospects and that these are known by management but not by outsiders.
Managers benefit if the company’s securities are more highly valued by the market but are
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penalized if the firm goes bankrupt because of their stakes in the firm. Under such
circumstances, the level of debt the company managers choose serves as a signal about the
quality of the company, a signal sent from the managers as insider information keepers towards
outside investors. Since lower quality firms have higher marginal expected bankruptcy costs for
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any debt level, managers of low quality firms do not imitate higher quality firms by issuing more
debt. Therefore as a result higher leverage is a good signal in this model by keeping in view both
of the perspectives discussed above.



The Determinants of Capital Structure: A Literature Review

The empirical research and results suggest a number of factors which influence the financial

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structure of companies as a major determinant. As discussed by Titman and Wessels (1988) and
Harris and Raviv (1991) that the choice of the underlying explanatory variables with respect to

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the dependent variables is selected with difficulty because they are the major determinants of the
research results. This is why different researchers have considered different key variables in their
respective studies because explanatory variables are totally different for each researcher.
However, most of the studies considered company size, profitability, liquidity, asset tangibility

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and firm growth prospects as possible determinants of the capital structure choice.

1. Company Size
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Company size is a major determinant for a firm to select a optimum capital structure. Larger
firms tend to be more diversified and less prone to bankruptcy (Rajan and Zingales, 1995), they
are also expected to incur lower costs in issuing debt or equity because of reach and collaborators
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who can help in getting finances. As a result, large firms are expected to hold more debt in their
capital structures than small firms and smaller firms tend to have less long term debt because of
shareholder lender conflicts (Titman and Wessels, 1988).
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2. Profitability

Another major determinant of capital structure is the profitability factor of a firm which is
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calculated through the ratios. Due to the tax deductibility of interest payments, it is argued that
highly profitable companies tend to have high levels of debt (Modigliani and Miller, 1963)
because of the higher figure of tax benefits compared to the firms with lower debt level.

3. Liquidity



Liquidity is also one of the major factors which must be taken into account for firms to take
capital structure decision; the major decision is about the level of debt financing. Liquidity
matters for all the public companies to show favorable results to shareholders, so companies by
keeping in view the liquidity level of the firm calculated by the corresponding liquidity ratios.

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The thirst to keep the liquidity funds like cash or equivalents in balance, companies decide about
the level of debt financing.

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4. Tangibility

The capital structure of a firm also depends on the ratio of the fix assets to the total assets of a

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firm. Because greater the ration, greater would be the assets to put as collateral against debt, so
greater the ratio the greater possibilities of debt inclusion in the capital structure of a firm.

5. Growth Opportunities
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Higher the growth opportunities of a firm are, higher the potential will be for that firm to go for
debt financing because definitely the return from the investment will be way higher than the
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cheaper option debt financing. The main reason is attributed in this way that higher the growth
opportunities of a firm are, higher would be the cash needs of that firm to finance new and
lucrative projects to take on.
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Other Major Factors are:

 Productivity
 Tax
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 Dividends
 Free Cash Flows
 Age of Firms
 Government



All of these factors mentioned above are somehow related to the determination of leverage of
companies; these factors are always taken into consideration when analyzing the capital structure
of a company or proposing an optimal structure to a company.

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Saudi Environmental Framework of Companies

It seems that all the companies must be having the same capital structure around the globe

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because of the globalization effects, all the companies are almost operating in more than one
country without regard of their national identity. But the empirical research has shown that all
the countries are capital structure specific even within G-7 countries’ companies have somehow
different capital structure depending upon their country specific attributes, although firms have a

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fairly similar capital structure across the G-7 countries, there were several institutional
characteristics that affect capital structure choice of those companies.

Saudi Arabia is an Islamic country. It is governed by the Islamic Law (Shari’ah), which is
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derived from the holy book of Islam (Qur’an) and the prophet (PBUH) guidance (Sunnah). The
institutional characteristics and socio cultural factors that are derived from the system mentioned
above and are expected to have influence on the determinants of the capital structure of Saudi
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companies are discussed below:

1. Central bank
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According to Saudi Arabia Monetary Agency (SAMA) official web sit (www.sama.gov.sa), the
top of Saudi Arabia’s financial system is SAMA, the central bank of the Kingdom of Saudi
Arabia. Since Its establishment in 1952, SAMA’s functions as defined by its charter issued in
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1952 and amended in 1957 include the following:

 Issuing and strengthening the Saudi currency and stabilizing its internal and external value
 Dealing with the banking affairs of the government
 Regulating commercial banks

2. Capital Markets



In Saudi Arabia, the specialized financial institutes do not exist. The capital market in Saudi
Arabia consists of the bond and the stock markets.

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2.1 Saudi Stock Market (SSM)

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Stocks remain the first choice for financing among listed companies whenever they are looking
for finances. Rajan and Zingales (1995) suggested that a good measure to determine the
importance of the stock market is the ratio of stock market capitalization to the gross domestic

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product (GDP). Rajan and Zingales (1995) compared the ratio of market capitalization to GDP
(62.3%) with the ratio of bank claims on the private sector to GDP (28.5%), and suggested that
equity is more important than private financing (bank debt).
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2.2 Bond market

The debt market consists of government bond market and corporate bond market. Bonds include
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treasury bills, which range from one week to one month in maturity; floating rate notes with
maturities at five years and seven years; and government development bonds (GDB) with
maturities at two, three, five, seven, and ten years; on the other hand, the corporate bond market
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has a short history because there is no well established market for bonds.

The Saudi bond market corporate bond market, in short, is negligible in the primary market.
Bonds are not liquid due to the non existence of secondary bond markets; this would suggest that
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bank loans are the main debt financing instrument in Saudi Arabia.

3. Legal system

One can say by looking at many research judgments of Saudi economy that the Saudi legal
system suffers from weak law and from weak enforcement of this law. These weaknesses as a



result would make the debt an expensive source of finance as the banks’ requirements become
more restrictive in lending to firms in such restrictive and unsecure legal system.

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4. Tax system

The main distinguishing feature of Saudi’s economy is the absence of income tax on citizens.

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Instead, there is one form of tax that is called Zakat, which is generally based on a payers’ net
worth not on performance. In Saudi Arabia, the government department of Zakat and Income
Tax (DZIT) is responsible to manage the religious obligation of Zakat and tax collection. The

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Zakat on the individual's annual income from any legal source amounts to 2.5%, a Saudi
company also pays 2.5%1 of the Zakat base. According to the department of Zakat and Income
Tax, Zakat base includes the share capital, retained earnings or accumulated deficit, long-term
loans, notes payable and advances if they are used to finance fixed assets. Furthermore, the
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adjusted net income for Saudi Income Tax and Zakat purposes is added to the Zaka base.
Deduction from the zakat base include net fixed assets and properties under construction,
dividends distributed during the year not to exceed retained earnings at the beginning of the year,
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investment in other Saudi companies and Saudi government bonds, and adjusted deficits. If the
Zakat base is negative or lower than the adjusted net income for the year, Zakat is imposed on
the adjusted net income. If both are negative, no Zakat is due.
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Barakat and Rao (2004) argued that in the non-tax Arab countries the debt usage is no different
from the equity usage as the payout on both is treated the same in the absence of tax advantages
of debt for the corporation, so the tax advantages of debt suggested by the trade off theory are
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expected to be minimal among Saudi firms.

5. Ownership pattern

La Porta, R., Florencio L. and Shleifer, A. (1999) found a relationship between legal protection
and ownership concentration in which countries with weak protection for investors tend to have

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Department of Zakat and Income Tax Saudi Arabia



higher ownership concentration and firms are typically controlled by families or the State.
Therefore, it is not surprising to find that company ownership is highly concentrated and mainly
controlled by families or the government in Saudi Arabia.

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Capital Structure of Saudi Companies

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The capital structure for major industries of Saudi companies is regressed by taking into account
the major determinants; we will discuss the capital structure of them with respect to major
industries.

Industrial Sector

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Sulaiman (Sulaiman A Al-Sakran, 2001) has mentioned the major factors in the paper and have
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come up with the capital structure determinants for the major industries. The companies with the
capitalization of more than 7 billion Saudi riyals were included, and for these industries interest
free short term loans were also provided by SIDF that’s why for the last half a decade they have
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shown equal long term and short term debt ratio otherwise it must have been very low compared
to the industries of other countries. This shows the relationship between the growth and the
capital structure as being a determinant. These industries have 21% (Sulaiman A Al-Sakran,
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2001) debt to capital ratio, although short term funds were provided at very favorable rates, this
ratio is lower as compared to the ratio of the industries of other contries.

Cement Sector
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From the last ten years, this sector has been showing higher growth rate compared to other
sectors of Saudi economy because of radical increase in demand. From the paper it is clearly
evident that the debt rate increased from 0% to almost 10% for this industry (Sulaiman A Al-
Sakran, 2001) as a result of higher growth rate and profitability, so it clarifies the correlation of
this determinant. This debt rate is substantially lower than the industry in other countries even in
other Arab countries.



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Electricity Sector

This sector is highly leveraged in Saudi Arabia because this is the only sector which is operated

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by Government of Saudi Arabia, so as being a subsidized industry this has got very high leverage
ratio of 60 % for last decade. If this would have not been so, the ratio would have been quite
lower as other industries have shown, because there is not a single feasible mechanism for debt.

Agriculture Sector

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The agricultural sector is the unique one in Saudi Arabia because of the lowest growth rate and
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profitability index when calculated for the last decade. Because of its unique attributes it is also
seen that the debt ratio for the last decade for this sector has been negligible, this is the sector
with lowest debt ratio compared to other sectors discussed above.
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Services Sector
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This is the sector with the highest growth rate in Saudi economy, but the debt ratio was not that
high because of lack of fix assets inclusion on the balance sheets of these companies, another
reason might be the unorganized debt market.
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Capital Structure in Other Countries and Determinants

As discussed above the capital of all the countries differ substantially, because the determinants
are country specific; all the economies are not alike and all capital structures differ in real sense.
The determinants can be considered same for whole of the countries but structure itself deviates
substantially if compared among countries. This is specifically for Saudi companies because they



are very low in correlation with others (Rajan and Zingales, 1995), we can make comparison of
the international companies with the Saudi companies now.

In general, the indebtedness of Saudi companies is very low compared to the level of debt of the

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companies in other countries found in previous studies. If compared to the international data, the
Saudi listed firms can be regarded as significantly under levered in term of total debt. The 10.9%
of total debt (Rajan and Zingales, 1995) is far below the 37%, 52%, 39%, 46%, 46%, 29%, and

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39% for United States, Japan Germany, France, Italy, United Kingdom, and Canada respectively.
To further confirm this fact, Figure below (Rajan and Zingales, 1995) provides a comparison
between the debt level components of the Saudi listed firms and their UK counterparts based on

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1997 data:
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Source: Figure made from the data provided in the Journal of Fianance of Rajan and Zingales
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(1995)

From this figure, it appears that there is a significant difference in financing preferences between
Saudi and UK companies in terms of total liabilities ratio. While this ratio constitutes 48.94% of
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the total assets of UK companies, it forms 27.2% of the total assets of Saudi companies.

On the other hand, it can be seen from the data provided in the paper (Rajan and Zingales, 1995)
that there are insignificant differences between average total bank debt (TD) of Saudi companies
and the total bank barrowing of UK companies (10.9% versus 10.5%). In term of short term and
long-term bank debt, also there are insignificant differences observed as the figure demonstrate.
The securitized debt is found to forms about 44% of the long-term debt. Therefore, it is not



surprise to observe lower long-term debt among Saudi companies since there is very weak
existence for bond debt.

Major Research Findings

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In the efforts to understand the incentives for a firm to use debt, finance scholars have developed

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various theories and models. Each theory has explained facts about one or more important
factors that might determine a firm’s capital structure. However, the findings of prior empirical
studies have resulted in confusing evidences related to the impact of these factors on the
formation of capital structure. Moreover, the majority of these studies have been conducted in

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western economies that have many institutional similarities like capital structure determinants
effects in the same way in all the selected English countries. Anyways, our knowledge of capital
structure within developing countries that often have different institutional characteristics
remains limited due to the lack of work that has been done in these countries especially in Saudi
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Arabia which has unique economic conditions.

Major findings about Saudi companies’ capital structure determinants
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The discussion below summarizes the main findings of the empirical research of Saudi
companies:
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The limited number of cross-country studies (e.g. Rajan and Zingales, 1995; Booth et al., 2001;
Giannetti, 2003; De Jong et al, 2007) confirms the importance of institutional factors in
explaining cross country capital structure differences, as economic factors which are totally
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different for each economy have direct effect on the capital structure determinants of a firm in a
specified country. The present study identifies a significant difference between the capital
choices of Saudi firms and firms in developed economies, and have resulted that Saudi firms
have substantially lower amounts of debt compared to other firms. The 10.9% total book-debt
level observed in listed companies is far below the figure in most developed countries. For
example, in 1991, the mean of total book-debt level in the G-7 countries was 41% (37% and 29%
in the United States and United Kingdom respectively) (Rajan and Zingales, 1995). It is also



below the average of total book-debt level of 32% in Arab countries (Barakat and Rao, 2004).
The substantially low amount of debt reflects the fact that the Saudi listed companies are mainly
financed by share capital rather than debt financing. The data of listed companies shows that
equity constitutes 57% of their assets.

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The major findings can also be classified as leverage by sector and leverage by size:

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Leverage by Sector

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It is evident from the research finding of (Sulaiman A Al-Sakran, 2001), that the leverage ratios
can be segregated according to sectors, as electronics industry has highest leverage ratio because
that is subsidized by government otherwise services industry with the highest growth did not
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have higher leverage ratio. The major finding are related to the determinants of the capital
structure, that growth and profitability really matters as approved by the regression models of the
research done by many researchers.
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Leverage by Size
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This is evident from the paper (Sulaiman A Al-Sakran, 2001) that as the firm gets larger, the debt
ratio also follows the suite, and whatever the economic structure and condition is. So this
testifies the leverage determinants as being the true factor to regress the variables.
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Suggestion for future research

This discussion has suggested some topics for future research; the following is a summary of the
important issues that should be considered in future research.

 The ignored different definitions in measuring both dependent and independent variables due
to time consideration or lack of data should be considered in future Meta analysis studies.



 The analysis has revealed that Saudi companies are missing an important debt instrument,
bond debt. This absence limits the financing choice for companies, which in turn may inhibit
their growth. Accordingly, it is strongly recommended that constraints related to bond

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issuance imposed on firms by company law should be considered for removal.

 The potential success for such instruments is very promising since Islamic law provides

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alternative corporate bonds such as Sukuk Al Ijarah that are gaining popularity in other
Muslim countries (e.g. Malaysia, Qatar and United Arab emirates).

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 The other recommendation is the establishment of a database containing data about Saudi
companies. The existence of such a database will encourage academics and other researchers
to conduct research not only in finance but in the business area in general.
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References

 Barakat, M and Rao, R. (2004), “The Role of Taxes in Capital Structure: Evidence from

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Taxed and Non-Taxed Arab Economies”, FMA, New Orleans meeting,working paper.

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 Booth, L., Aivazian, V., Demirguc-Kunt, A., and Maksimovic, V. (2001), “Capital
Structures in Developing Countries”, Journal of Finance, Vol. 56, No. 1, pp. 87-130.

 De Jong, A., Kabir, R., and Nguyen, T. T. (2007), “Capital Structure around the


Finance, forthcoming. .

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World: The Roles of Firm- and Country-Specific Determinants”, Journal of Banking &

Giannetti, M. (2003), “Do Better Institutions Mitigate Agency Problems? Evidence from
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Corporate Finance Choices”, Journal of Financial and Quantitative Analysis, Vol. 38,
pp.185-212.
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 Harris, M. and Raviv, A. (1991), “The Theory of Capital Structure”, Journal of
Finance, Vol. 46, No. 1, pp. 297-355.
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 Leland, H. and Pyle, D. (1977), “Informational Asymmetries, Financial Structure
and Financing Intermediation”, Journal of Finance, Vol. 32, No. 2, pp. 371- 388.

 La Porta, R., Florencio L. and Shleifer, A.(1999), “Corporate Ownership around the
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World”, Journal of Finance, Vol. 54, No. 2, pp. 471-517.

 Modigliani, F. and Miller, M. H. (1958), “The Cost of Capital, Corporation Finance and
the Theory of Investment”, American Economic Review, Vol. 48, No. 3, pp. 261-297.

 Modigliani, F. and Miller, M. H. (1963), “Corporate Income Taxes and the Cost of



Capital: A Correction”, American Economic Review, Vol. 53, No. 3, pp. 433-443.

 Myers, S. C. (1977), “Determinants of Corporate Borrowing”, Journal of Financial
Economics, Vol. 5, No. 2, pp. 147-175.

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 Myers, S. C. (1984), “The Capital Structure Puzzle”, Journal of Finance, Vol. 39,
No. 3, pp. 575-592.

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 Myers, S. C. and Majluf, N. (1984), “Corporate Financing Decisions and
Investment Decisions When Firms Have Information That Investors Do Not Have”,

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Journal of Financial Economics, Vol. 13, No. 2, pp. 187-221.

 Rajan, R. G. and Zingales, L. (1995), “What Do We Know about Capital Structure?
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Some Evidence from International Data”, Journal of Finance, Vol. 50, No. 5, pp. 1421-
1460.
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 Ross, S. (1977), “The Determination of Financial Structure: The Incentive
Signalling Approach”, Bell Journal of Economics, Vol. 8, No. 1, pp. 23-40.
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 Sulaiman A Al-Sakran, (2001), “Leverage determinants in the absence of corporate tax
system”, Managerial Finance; 2001; 27, 10/11; ABI/INFORM Global pg. 58

 Titman, S. and Wessels, R. (1988), “The Determinants of Capital Structure Choice”,
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Journal of Finance, Vol. 43, No. 1, pp. 1-19.


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