Since the development of the Saudi Arabian stock market in 2003, corporations have been able to substitute equity for debt more freely. However, new banks have entered the financial market, giving corporations more opportunity to borrow funds. Both fund resources (loan and equity) have experienced their own crises. This research was conducted to investigate the effect of the debt and equity mix, as measured by financial leverage, on a firm’s financial performance. It focuses on profitability, specifically in the Saudi Arabian capital market. This study was developed to extend understandings in the literature of how financial leverage operates in a no-interest based financial system, and how it may affect financial performance. This research examined 57 publicly trading firms listed in the Saudi Arabian stock market between 2002 and 2010. This study extends the understandings previously reported in the literature of how financial performance is linked to financial structure, zakat (Islamic tax), and the ages and sizes of Saudi Arabian firms in a no-interest based financial system. A great motivator of this study was the 2006 Saudi Arabia stock market collapse and the 2008 global financial crisis (GFC) which lowered the businesses’ trust in bank loans as a source of funds.\ud
The overall results of this study were that, in the long term, in the absence of acute economic downturns, lower leverage levels tend to lead to higher profit margins and returns on both assets and equity. It also provides evidence to recommend that, under normal economic conditions, Saudi Arabian firms could attempt to improve their financial performance by balancing their zakat liabilities with their leverage borrowing levels. Another recommendation made by this study is that more studies are needed to examine zakat calculation standards and zakat’s effect on firms’ capital structure and society. The way zakat is calculated and presented in firms’ financial statements is currently vague. Thus, a separate study to examine the effect of zakat on capital structure and financial performance for each sector may provide more in-depth knowledge about this relationship