The Effect of Financial Leverage on Profitability and Risk of Restaurant Firms

This study presents an empirical insight into the relationship between return on equity (ROE), financial leverage and size of firms in the restaurant industry for the period 1998 to 2003 using OLS regressions. Research results suggest that at least during the test period firm size had a more dominant effect on ROE of restaurant firms than debt use, larger firms earning significantly higher equity returns. Results also suggest that regardless of having lower financial leverage, smaller restaurant firms were significantly more risky than larger firms. As such, the dominance of size effect in the ROE-financial leverage relationship within the restaurant industry is better understood. INTRODUCTION It has been reported that many new restaurants start up but one of three new restaurants in the United States fails within 2 years (Ernst, 2002). According to Ernst (2002), the lack of a financial plan is one of the most common reasons for restaurant business failure, following choosing the wrong location. Financial planning is an important part in the restaurant business because the restaurant industry has higher percentage of cost of sale than other industries. A national survey in 2000 evidenced that 61 cents was consumed as food and labor costs for every dollar earned in full-service hotel restaurants, excluding other costs such as interest expense and rent (Ernst, 2002). Because of the high-cost nature of the business, the profitability of restaurant firms may be related to the level of interest expenses that are incurred due to the firms’ debt use. According to previous studies, financial leverage affects cost of capital, ultimately influencing firms’ profitability and stock prices (Higgins, 1977; Miller, 1977; Myers, 1984;