Exploring the Nexus between Debt Financing and Firm Performance: A Robustness Analysis Using Instrumental Variables

Abstract

This study explores the impact of debt financing on firm performance, focusing on addressing the challenges of endogeneity and collinearity in regression models. Using a sample of firms from the CSMAR database, we investigate how different forms of debt financing short-term debt, long-term debt, and total debt affect firm performance metrics, specifically Return on Equity (ROE) and Return on Assets (ROA). To mitigate potential biases in traditional regression models, we employ Generalized Two-Stage Least Squares (G2SLS) and instrumental variable (IV) techniques. Our results show that long-term debt (LTDTA) and total debt to total assets (TDTA) have significant effects on firm performance, with some mixed relationships observed between debt financing variables and performance outcomes. The study further addresses issues of collinearity and endogeneity, demonstrating that the use of robust standard errors and instrumental variables provides more reliable estimates. The findings highlight the importance of strategic debt management for firms aiming to optimize performance while minimizing risks associated with excessive leverage. This study contributes to the literature on capital structure and firm performance, offering implications for financial managers, investors, and policymakers. Future research could extend these findings by exploring the effects of other financing sources and firm-specific characteristics across different industries.