This paper contributes to the corporate governance literature by examining the effect of corporate governance characteristics on financing decisions in Saudi Arabian listed companies. In particular, we examine the effect of board size; ownership concentration and corporate governance reporting on the debt-to-equity ratio. We use a multiple regression model to examine how corporate governance variables affect the extent to which Saudi Arabian companies use debt to finance their activities.
We use a sample of 37 companies listed in Saudi Stock Market in January 2006 which is based on a recent paper by Hussainey and Al-Nodel (2008) who collected their sample from Saudi listed companies’ websites between October 2005 and January 2006 representing a total number of 77 companies. This helps us to focus on a group of firms that report corporate governance information on their websites
After controlling for companies’ profitability and their growth opportunities, we find that both board size and ownership concentration are positively associated with debt-to-equity ratio. The findings seem to suggest that managers are likely to choose higher financial leverage when they have stronger corporate governance (large number of directors on the board and higher ownership concentration). However, the empirical results of the relationships are statistically insignificant in the case of corporate governance reporting. This suggests that firm’s asymmetric information is not an important driver of the financing decision of Saudi Arabian companies. This might be due to the nature of the Saudi business environment.
Capital structure decision is a well established part of the accounting and finance research related to determinants of corporate capital structure. Modigliani and Miller (1958) is the first to study this area of research. They find that capital structure decision is unrelated to firm value. They also relax the prefect market assumptions and consider corporate tax into their models (Miller and Modigliani, 1963). Consequently, they find that firm value will be enhanced if the level of debt increases. They explain their findings by the fact that interest rate is a tax deductible and consequently companies would enjoy debt tax shield when funding their activities by long-term debt. However, Miller and Modigliani (1963) don not taken into account the bankruptcy related costs. A natural area of extending these lines of research is to explore other drivers of corporate capital structure decisions.
Previous studies offer evidence that corporate governance variables affect firms’ capital structure decisions (Wen et al., 2002; Du and Dia, 2005; La Rocca, 2007; Driffield et al., 2007; Al-Najjar and Hussainey, 2009a, 2009b). However, there are a very limited number of studies that have examined determinants of capital structure in developing countries and even fewer such studies may be found in the Middle Eastern countries. To the best of our knowledge, no study yet has examined the influence of corporate governance on capital structure decision in Saudi Arabia or Middle Eastern countries. Consequently, this paper is the first to examine the potential corporate governance factors that might drive Saudi Arabian firms to use debt as the main source of finance.
This paper is also motivated by the fact that SACMA issued a guidance in 2006 that recommends all listed companies to disclose corporate governance information to the public. Therefore, it would be worthwhile examining the attitude of companies to volunteer report corporate governance rather than being enforced to do so.
The paper proceeds as follows. Sections 2 and 3 review prior research on the determinants of capital structure and develop the research hypotheses. Section 4 discusses the research method. Section 5 is the data description. The main regression results are presented in Section 6. Finally, Section 7 concludes and suggests areas for future research.
For placing the findings of this study within its context, as well as other environments with similar characteristics this section provides a general description of the environment of the Saudi business practices.
Several environmental factors affect Saudi business practice, this section, however, will summaries some of the most important environmental factors, as suggested by the literature such as the political, economical, and social systems and the 1965 Company Law that regulates the practice of Saudi businesses and the guidance of corporate governance issued by SACMA in 2006.
As similar to most countries in the Middle Eastern region, the early stage of the political, economic and social development in the country makes the environment of the Saudi audit practice significantly different from that in developed countries.
The political system of Saudi Arabia is a monarchy, headed by the King. Within the political system, there are three legislative bodies, which have the authority to initiate and/or approve policies, regulation or rules: the Council of Ministers, the Consultative Council, and various individual Ministries. There are various groups within the political system influence major policy issues and the development of new regulations. The main groups are the royal family, Islamic scholars, state officials, liberal elites, academics, tribal leaders and businessmen; all of whom have different interests and different powers depending on the importance of the issue to its interests and affairs (Al-Amari, 1989; Al-Rumaihi, 1997; Aba-Alkhail, 2001; Economist Intelligence Unit, 2003; Al-Nodel 2004). The Basic Law of Government which was introduced in 1992 is considered to be the constitution of the KSA (Economist Intelligence Unit, 2003).
As an Islamic country, the legal system of Saudi Arabia is derived from Islamic law (Shariah; Alqur’an Alkareem and Sunna Alsharifah), and coded laws for a number of specific fields, such as commerce, tax and labour. Al-Amari (1989) reported that Islamic law, however, prevails in legal disputes.
Saudi society is heavily influenced by its Arabic heritage and Islamic values (Al-Rumaihi, 1997; Aba-Alkhail, 2001; Al-Nodel 2004). All Saudis are Muslim, and the Arab Peninsula is the birthplace of Islam. Al-Rumaihi (1997) described Saudi society as characterised by the impact of the personality and power of particular individuals, the role of family and friend relationships over regulations, privilege given to personal relationships over tasks, and the existence of a high level of secrecy.
The economy of Saudi Arabia is an oil-based economy and government exercises strong controls over major economic activities. It possesses 25% of the world’s proven petroleum reserves, ranks as the largest exporter of petroleum, and plays a leading role in OPEC. Worldwide oil prices and production volumes strongly affect Saudi economy. Since the discovery of oil in 1938, oil revenue represents the biggest contribution to the economy. In 1990s, it accounted for around 35% of nominal GDP, about 75% of government revenues, and 85% of export receipts (Economist Intelligence Unit, 2003). Table 2 presents the country’s budgetary revenues, expenditures and net surplus or (deficit) for the last three years.
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Noticeable features of the current practice of Saudi companies are the domination of family businesses, the deep involvement of the government in the private sector, and the existence of a number of foreign-owned and controlled companies based on joint venture agreements with domestic companies.
The domination of family businesses type in Saudi Arabia is argued by Al-Nodel (2004). He explained that joint-stock companies represent only 1.14% of the total number, and account for less than 40% of the total capital of the registered businesses.
The existence of a number of foreign-owned and controlled companies based on joint venture agreements with domestic companies and the involvement of government in businesses represents another significant feature of the Saudi private sector (Presley, 1984; Aba-Alkhail, 2001).
The 1965 Company Law regulates the practice of businesses in Saudi Arabia. It sets conditions for establishing businesses, describes the legal framework for business, and requires the publication of annual financial statements audited by an independent party (see also Al-Rehaily, 1992; Aba-Alkhail, 2001 and Al-Nodel 2004). Articles of the 1965 Company Law sets conditions for several aspects of businesses such as legal frameworks through which business companies can be established, the registration requirements, minimum capital to be maintained, number of partners, number of directors, accounts, the annual audit of the accounts, and so on. Shinawi and Crum (1971) asserted that the origin of the 1965 Saudi Company Law goes back to the British Companies Act of 1948. The similarity between the 1965 Saudi Company Law and the UK acts issued in 1948, 1967 and 1976 was also reported by Kahlid (1983).
The main features of the 1965 Company Law are the legal frameworks of businesses and the reporting requirements. It provides several legal frameworks through which business companies can be established such as general partnership, joint venture, joint-stock company, limited liability company, and cooperative company  .
The 1965 Company Law also sets the reporting requirements of businesses. It requires the issuance of a balance sheet, a profit and loss account, and a report on the company’s operations and financial position every fiscal year. It further stipulates that all corporations, and limited liability companies must issue annual financial statements audited by an independent auditor licensed to practice by the Saudi Ministry of Commerce and Industry.
The stock market of Saudi Arabia is underdevelopment. In 1984, the Royal Decree No. 81230 was issued as an attempt to officially regulate the stock exchange (Abdeen and Dale, 1984; El-Sharkawy, 2006). Under this Royal Decree, the Saudi Arabian Monetary Agency (SAMA) was given actual control over the stock exchange through national commercial banks.
The significant change was in 2003 when the Saudi Arabian Capital Market Authority (SACMA), which took responsibility from SAMA to oversight the exchange of Saudi stocks, was established (Ramady, 2005). This period observed significant changes with respect to the number of listed companies or market value. Table (3) compares some key numbers of the Saudi stock market between 1996- 2005.
Insert Table 2 here
In 2006 SACMA intensifies its efforts to provide fairness in the trading of the Saudi stocks. Among these efforts was the issuance of the draft of corporate governance for listed companies in 2006. The draft provides recommendations of the criteria for the best corporate governance practice that should listed companies counsel. It has covered to some extent the main five principles issued by the Organization for Economic Co-operation and Development (OECD): the rights of shareholders, the equitable treatment of shareholders, the role of stakeholders in corporate governance, disclosure and transparency, the responsibility of the board of directors.
According to the recommendations of SACMA, listed companies are required to report to SACMA about their compliance with the criteria of corporate governance as issued by SACMA or reasons for uncompliance if any. The disclosure contains, for example, the board of directors’ functions, responsibilities, formation, committees of board of directors; audit committee; Nomination and Remuneration Committee; Meetings of the Board and Remuneration and Indemnification of Board Members  .
Finally, SACMA asserted that the criteria for the best corporate governance practice mostly constitutes the guiding principles for all listed companies unless any other regulations, laws or rules require such requirement.
Although, corporate governance has been the subject for an extensive research in developed countries  , limited research has been carried out to investigate the issue of corporate governance in business environment of developing countries. Furthermore, those limited research studies approach the issue whether to describe the state of corporate governance from an official perspective or from the perspective of what should the practical applications of its principles be.
For example, Al-Motairy (2003) explores the state of corporate governance practices in Saudi Arabia. He concludes that there is a vital need for (1) a review of these regulations to reflect the current practices of corporate governance, (2) the issuance of guidance for best practices for management and financial affair in corporations and (3) the establishment of an organisation to accelerate the adoption of best practices of corporate governance.
Similarly, Fouzy (2003) evaluates the practices of corporate governance’s principles in Egypt. He recognises the development in Egyptian official regulations toward the application of best practices of corporate governance. He then argues that these developments are not met enough by Egyptian companies in their practical applications.
Another example is the study which was carried out by Oyelere and Mohammed (2005) investigating the practices of corporate governance in Oman and how it is being communicated to stakeholders. They recommend enhanced regulation and communication for the Omani stock market to keep pace with the international developments.
Finally, a research paper by the Centre for International Private Enterprise (CIPE, 2003) examines the corporate governance practice in four Middle Eastern countries (Egypt, Jordan, Morocco, and Lebanon). It finds that corporate governance practice is approached differently by each country. This is depended on the sophistication of the financial market in each country. The research paper further provides several recommendations to improve the application of the principles of corporate governance in the region as a whole.
In conclusion, research studies that investigated the issue of corporate governance assert the importance of better regulations of the corporate governance in the region in order to increase the public confidence in financial markets
Although the relationship between corporate governance and capital structure has been the subject for an extensive research in developed countries, limited research has been carried out to investigate the issue in business environment of developing countries. In the subsequent paragraphs we formulate three research hypotheses.
The association between board size and capital structure decisions have been well established in prior accounting and finance research. In particular, Mehran (1992), Berger et al. (1997), Wiwattanakantang (1999), Wen et al. (2002), Du and Dia (2005), Abor and Biekpe (2005) and Al-Najjar and Hussainey (2009a and 2009b) examine the association between board size and corporate capital structure decision, but the results are mixed.
Mehran (1992), Berger et al. (1997), and Abor and Biekpe (2005) find a significant negative association between the size of the board of directors and debt-to-equity ratios. However, Jensen (1986) finds a positive association between higher debt ratios and larger board size. Other researchers (Wiwattanakantang, 1999; Wen et al., 2002; Al-Najjar and Hussainey, 2009) find that there is no significant association between board size and debt-to-equity ratios.
Given the above mixed results, we also revisit this research area and examine the association between board size and capital structure for Saudi Arabian companies. We set the following first research hypothesis for the impact of board size on capital structure:
H1: Ceteris paribus, there is a relationship between board size and debt-to-equity ratio.
Ownership concentration is considered as one of the key determinants of capital structure decision. Wiwattanakantang (1999) finds that managerial shareholdings have consistent positive influence on family-owned firm leverage. In addition, Al-Najjar and Hussainey (2009a) find that insider ownership is positively and significantly associated with the debt-to-equity ratio. However, Al-Najjar and Hussainey (2009b) did not find the expected significant results.
Given the above results are – to some extent – mixed, we also revisit this research area and examine the association between ownership concentration and capital structure for Saudi Arabian companies. We set the following second research hypothesis for the impact of ownership concentration on capital structure:
H2: Ceteris paribus, there is a relationship between ownership concentration and debt-to-equity ratio.
A new and growing number of studies have investigated the association between asymmetric information and corporate decisions (see Li and Zhao, 2006 for more details). In a recent paper, Bharath et al. (2009) use a novel information asymmetry index and examine the extent to which information asymmetry is a determinant of capital structure decisions. They found that information asymmetry affects capital structure decisions of US companies. In particular, they found a significant positive association between information asymmetry and debt-to-equity ratio. In other words, their results suggest that firms will higher levels of information asymmetric are more likely to use debt in financing their activities than equity.
Based on the above results, we explore the role of the information environment on capital structure decision in Saudi Arabian companies. We use a corporate governance voluntary disclosure index as a measure of a firm’s information environment. Prior research finds that voluntary disclosure is negatively related to asymmetric information. For example, Hussainey et al. (2003) find higher levels of voluntary disclosure reduce information asymmetry between the firm and investors and hence increase investors’ ability to better anticipate future earnings. We set the following third research hypothesis for the impact of corporate governance reporting on capital structure:
H3: Ceteris paribus, there is a negative relationship between corporate governance reporting and debt-to-equity ratio.
In order to test the above hypotheses, we regress debt-to-equity ratio on some corporate governance characteristics and some control variables. The study will investigate the following model:
is defined as long term debt to equity ratio; is the intercept. is the slope coefficient estimates of regressors. is the corporate governance variables (and control variables) for firm i at time t.
The dependent variable () is defined as the long term debt to equity ratio.
We have three independent variables and two control variables. We identify three types of corporate governance variables:
(1) Board size (BOARD): This represents the number of executive and non executive directors on the board.
(2) Ownership concentration (OWNERSHIP): This represents the total percentage of the company’s shares that owned by owners.
(3) Corporate governance reporting (DISCLOSURE): This is calculated as the number of sentences that include at least one corporate governance related information.
(1) Profitability (PROF): we use return on total assets as a measure for firms’ profitability.
(2) Growth opportunity (MB): we use share price to book value ratio as a measure for firm’s growth opportunity.
Our data collection is based on a recent paper by Hussainey and Al-Nodel (2008). This helps us to focus on a group of firms that report corporate governance information on their websites. Hussainey and Al-Nodel (2008) collected their sample from Saudi listed companies’ websites between October 2005 and January 2006. At that time, the total number of companies listed in the Saudi Stock Market was 77 representing eight sectors: agriculture, services, cement, industrial, banks, electrical, telecommunication and insurance. They used TADAWUL website (www.tdwl.net) and Google website (www.google.com) to access every company’s website. They deleted some companies from their analysis for a number of reasons. These include 11 firms without websites; one firm with a website under construction and one firm with a restricted website. This reduced their sample to 64 companies. We also further 27 firms because of missing corporate governance and accounting information. This leads to a sample of 37 listed firms for the current study.
Data on debt-to-equity ratio, Board size, ownership concentration, profitability and price-to-book value ratio are collected from TADAWUL website. Following Hussainey and Al-Nodel (2008), we use the content analysis approach to measure the number of sentences that contain corporate governance information. Accordingly we use the corporate governance disclosure index developed by Hussainey and Al-Nodel (2008) to analyse the content of every company’s website.
This section discusses the descriptive analysis, the correlation analysis and the empirical results.
Table 1 shows the descriptive analysis (mean, minimum, maximum and the standard deviation). It shows that on average the number of directors on board in Saudi Arabia companies is around 8, with a minimum of 4 members and a maximum of 11 members. Mean ownership concentration is 35.6 and the mean corporate governance disclosure is 5 sentences with a minimum of zero corporate governance sentence and a maximum of 21 corporate governance sentences.
A broad range of variation in financial variables is also evident in our sample. The debt-to-equity ratio ranges from 0 to 97 with a mean of 24.52 and a standard deviation of 32.576. The return on total assets ratio ranges from -37.3 to 71.74 with a mean of 8.8535 and a standard deviation of 13.81767. The share price to book value ratio ranges from 0 to 21 with a mean of 5.03 and a standard deviation of 5.336.
Insert table 3 here
Table 2 shows the correlation analysis. The correlation between each of the independent variables is not too high. The highest correlation found between corporate governance disclosure and share price to book value ratio (MB) is 43.5, which is acceptable. This confirms that no multicollinearity problem exists between the independent variables.
Insert table 4 here
Table 3 shows our empirical results. It shows that the coefficient estimate on board size is positive significant with a p-value of 0.059 (see model 4). This is consistent with Jensen (1986) who also finds a positive association between higher debt ratios and larger board size. Our finding indicates that larger board size puts Saudi Arabian firms in a good position to finance their activities by using debt. This is consistent with the fact that higher quality of corporate governance improves companies’ financial performance (Bhagat and Bolton, 2008) and hence leads increase the ability of the company to obtain debt. Liang and Zheng (2005) provide an explanation for this positive sign. They argue that boards with a large board size are more likely to have a difficulty in getting an agreement because of different and conflict opinions and views. Accordingly, firms with large number of directors on board might not choose equity financing which requires high transaction cost to resolve communication and coordination dilemma. In addition, they argue that directors would choose debt for financing their activities because this source of finance will not dilute the equity of current shareholders and change their current position. This leads us to accept hypothesis 1.
Table 3 also shows that the coefficient estimate on ownership concentration is positive significant with a p-value of 0.005 (see model 4). This result is consistent with Wiwattanakantang (1999) Al-Najjar and Hussainey (2009a). This indicates that when the total percentage of the company’s shares is concentrated internally, managers will prefer to use debt to finance their companies’ activities. This is because – as mentioned in Liang and Zheng (2005) – debt will not dilute the equity of current shareholders and change their current position. This leads us to accept hypothesis 2.
Finally, corporate governance disclosure as a proxy for asymmetric information between managers and investors is expected to be negative and statistically significant. However, Table 3 shows that the coefficient estimate of DISCLOSURE variable is positive, indicating that firms with higher levels of corporate governance disclosure (less information asymmetry) has higher debt-to-equity ratio. This finding is statistically insignificant and not consistent with prior research. This leads us to reject hypothesis 3.
The aim of this paper was to examine the effect of corporate governance mechanisms on capital structure for Saudi Arabian listed companies. Our results show that the corporate capital structure decisions in Saudi Arabia is driven by some of the same corporate governance determinates suggested in prior research. Based on a sample of 37 Saudi Arabian listed companies, our results show that the number of directors on boards and ownership concentration are the main drivers of Saudi companies for capital structure decisions.
As mentioned in Hussainey and Al-Nodel (2008), the main limitation of the study is that it did not cover the whole market so the sample may not be representative of the population of Saudi companies. This, however, is justified by the nature of the study, which relied on the availability of companies’ websites. So companies that are not included in our study are more likely to have either no website, with a website under construction or the access to the information in their website is restricted. This is evident by checking the type of companies, which are not included. We found that these companies are in general small and less likely to use the online reporting. Nevertheless, a study with a large number of companies is needed for future research.
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