International Journal of Business and Social Science Vol. 3 No. 16 [Special Issue – August 2012] 104 The Relationship between Capital Structure and Profitability Dr. Mohammad Fawzi Shubita Assistant Professor Department of Accounting Amman Arab University Amman – Jordan Dr. Jaafer Maroof alsawalhah Assistant Professor Head of Accounting Department Philadelphia University Amman – Jordan Abstract This study seeks to extend Abor’s (2005), and Gill, et al., (2011) findings regarding the effect of capital structure on profitability by examining the effect of capital structure on profitability of the industrial companies listed on Amman Stock Exchange during a six-year period (2004-2009). The problem statement to be analyzed in this study is: Does capital structure affect the Industrial Jordanian companies? The study sample consists of 39 companies. Applying correlations and multiple regression analysis, the results reveal significantly negative relation between debt and profitability. This suggests that profitable firms depend more on equity as their main financing option. Yet recommendations based on findings are offered to improve certain factors like the firm must consider using an optimal capital structure and future research should investigate generalizations of the findings beyond the manufacturing sectors. Keywords: Short term Liabilities, Long term liabilities, Return on Equity, Amman Stock Exchange. 1. Introduction The capital structure is defined as the mix of debt and equity that the firm uses in its operation. The capital structure of a firm is a mixture of different securities. In general, firms can choose among many alternative capital structures. For example, firms can arrange lease financing, use warrants, issue convertible bonds, sign forward contracts or trade bond swaps. Firms can also issue dozens of distinct securities in countless combinations to maximize overall market value (Abor, 2005). Firms can use either debt or equity capital to finance their assets. The best choice is a mix of debt and equity. In the case where interest was not tax deductible, firms’ owners would be indifferent as to whether they used debt or equity, and where interest was tax deductible, they would maximize the value of their firms by using 100% debt financing (Azhagaiah and Gavoury, 2011). The use of debt in capital structure of the firm leads to agency costs. Agency costs arise as a result of the relationships between shareholders and managers, and those between debt- holders and shareholders (Jensen and Meckling, 1976). The pecking order hypothesis suggests that firms are willing to sell equity when the market overvalues it (Myers, 1984; Chittenden et al., 1996). This is based on the assumption that managers act in favor of the interest of existing shareholders. Consequently, they refuse to issue undervalued shares unless the value transfer from “old” to new shareholders is more than offset by the net present value of the growth opportunity. It can be concluded that new shares are only issued at a higher price than that imposed by the real market value of the firm. Therefore, investors interpret the issuance of equity by a firm as signal of overpricing. If external financing is unavoidable, the firm will opt for secured debt as opposed to risky debt and firms will only issue common stocks as a last resort (Abor, 2005).