Leverage and Firm Performance: New Evidence on the Moderating Role of Macroeconomic Conditions

Abstract

This study investigates the relationship between financial leverage and firm performance and examines the moderating role of macroeconomic conditions among GCC-listed firms. While prior studies have primarily focused on the direct effect of leverage on firm performance, comparatively limited attention has been devoted to understanding how macroeconomic conditions shape the relationship between financial leverage and firm performance in emerging markets. Drawing on Trade-off Theory, Agency Theory, and Contingency Theory, this study argues that the effectiveness of financial leverage depends on prevailing macroeconomic conditions. Using a panel of GCC-listed firms over the period 2016–2023, the analysis employs a dynamic two-step System Generalized Method of Moments (System GMM) estimator to address endogeneity, unobserved firm heterogeneity, and the persistence of firm performance. Firm performance is measured using return on assets (ROA), return on equity (ROE), and Tobin’s Q. The baseline results reveal that financial leverage has a significant negative effect on both accounting-based and market-based measures of firm performance, suggesting that the costs associated with excessive debt outweigh its financing benefits. The moderation analysis further reveals that macroeconomic conditions exert heterogeneous effects on this relationship. Specifically, GDP growth mitigates the adverse effect of financial leverage on ROA, whereas inflation mitigates the adverse effect on ROE but reinforces the adverse effect on Tobin’s Q. These findings demonstrate that the impact of financial leverage on firm performance is contingent upon prevailing macroeconomic conditions and varies across accounting-based and market-based performance measures. The study contributes to the capital structure literature by integrating firm-level financing decisions with macroeconomic conditions and extending the explanatory power of Trade-off Theory, Agency Theory, and Contingency Theory by demonstrating how macroeconomic conditions shape the relationship between financial leverage and firm performance in the GCC context. The findings also have important implications for corporate managers, investors, and policymakers by emphasizing the need to incorporate macroeconomic conditions into capital structure decisions and adopt adaptive financing strategies to promote sustainable firm performance under changing macroeconomic conditions.