Liberal Arts & Social Sciences International Journal (LASSIJ)

eISSN: 2664-8148 (online)

https://www.ideapublishers.org/index.php/lassij
Vol. 7, No. 1, (January-June) 2023, pp. 24-38
Research Article | Original Research https://doi.org/10.47264/idea.lassij/7.1.2

Impact of corporate governance on firm performance: a case of Pakistan

stock exchange
Khalid Mumtaz Khan*1 | Zahid Mahmood2
1. Department of Business Studies, Bahria Business School, Bahria University, Islamabad, Pakistan.
2. Department of Management, College of Business Administration, King Saud University, Saudi Arabia.

*Corresponding Author Emails: khalid@bahria.edu.pk | khalidmumtazmail@gmail.com

Abstract

This study investigates the impact of Corporate Governance on Firm Article History
Performance. Corporate governance has been operationalized through eight
Received:
indicators, including the Board Size, Ownership Structure, CEO Duality,
24-Mar-2023
Independence of Audit Committee, Firm Size, Firm Age, Firm Leverage,
and Firm Growth. At the same time, the Firm's performance has been Revised:
factored into Return on Assets and Return on Equity. Pakistan stock 24-Apr-2023
exchange has been used as the unit of analysis, taking 100 public listed firms
from the non-financial sector as the sample. Using suitable statistical tools, Re-revised:
data around the study variables have been collected and analyzed for ten 28-May-2023
years, i.e., 2013-2022. The findings reveal that lean board size, moderate
leverage, CEOs serving on various boards, high independence on audit Accepted:
committees, large firm size, young firms, and sustainable growth positively 30-May-2023
impact the firm performance. High leverage has been found to have an
Published:
adverse impact on firms' profitability, especially in the wake of high
08-Jun-2023
interbank offered rates. These findings are important to practitioners,
corporate regulators, and researchers. Future studies are recommended to
take more indicators from the corporate governance index into account for
understanding their impact on firm performance.

Keywords: PSX, CGI, corporate governance, firm performance, board size, firm age, firm
growth, audit committee.

How to Cite: Khan, K. M. & Mahmood, Z. (2023). Impact of corporate governance on firm
performance: a case of Pakistan stock exchange. Liberal Arts and Social Sciences International Journal
(LASSIJ), 7(1), 24-38. https://doi.org/10.47264/idea.lassij/7.1.2

Publisher’s Note: IDEA PUBLISHERS (IDEA Journals Group) stands neutral with regard to the
jurisdictional claims in the published maps and the institutional affiliations.

Copyright: © 2023 The Author(s), published by IDEA PUBLISHERS (IDEA Journals Group).

Licensing: This is an Open Access article published under the Creative Commons Attribution-
NonCommercial 4.0 International License (http://creativecommons.org/licenses/by-nc/4.0/)
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1. Introduction

The corporate governance has attracted significant attention from researchers and practitioners
in the recent past, for its ability to influence the firm performance. This study aims at measuring
the impact of selected indicators of corporate governance on the firm performance for selected
firm listed at Pakatan Stock Exchange (PSX). Corporate governance today, stands as a well-
defined and measurable phenomenon. It is now considered as a corner stone for a firm’s success
or failure. In the same context, the securities and exchange commission (SEC) globally, have
revised their respective code of corporate governance. A better corporate governance code
ensures the protection of stakeholders’’ interests within the firm, in addition of ensuring the
existence of fair and equitable markets for the economic actors.

The corporate governance in based on the principles of accountability, transparency,

responsibility, and risk management. The corporate governance index (CGI) measures the
effectiveness of the corporate governance mechanism. It comprises of five sub-indices
including, disclosure, board structure, ownership structure, shareholders rights, board
procedures, and control on related party transactions. Each sub-indices contains a set of
indicators, which indicate the degree of a firm’s compliance towards the code of corporate
governance. Better compliance is expected to result in better firm performance in addition on
exhibiting better corporate citizenship on the part firm.

Based on, but not limited to, the principles of accountability, fairness, transparency, assurance,
leadership, and stakeholders’ management, the corporate governance is a system of processed,
practices, and rules to govern or control a corporate entity (Chaarani et. al., 2022). A good
corporate governance system ensures the provision of integrity, transparency, fairness, and
efficiency to financial markets. While a poor corporate governance system allows the growth
of malpractices within the financial markets along with lack of stakeholders trust in the market
regulators’ ability to protect their stakes in the market (Zafar, 2022). It may also lead to lack of
accountability, negligence, corruption, frauds, and even corporate failure in form of defaults
and bankruptcies (Jayasekara et. al., 2022). There are various dimensions of corporate
governance, however the relevant ones taken into account for the purpose of this study have
been discussed in the review of literature.

The findings reveal that these indicators effect the firm performance with different degree and
magnitude. These findings are of material significance for the corporate regulators and firm
managers, in terms of enhanced compliance towards the code of corporate governance and
better firm performance. Furthermore, these findings add towards the existing body of
knowledge on Pakistan stock exchange, which is emerging stock exchange, and needs
researchers’ attention to understand the challenges unique to this market. These findings also
help in improving the corporate governance index for the Pakistan stock exchange.

Based on the studies encountered in the corporate governance, the key objective of the study
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is to investigate the relationship between corporate governance and firm’s performance

regarding economy of Pakistan. Concisely, yet encompassing the circumference of this study,
the theoretical framework and related hypotheses of this study are;

1.1. Conceptual framework of the study

Figure 1

Corporate Governance Firm Performance

1. Board Size 2. Ownership Structure 3. CEO Duality 4. 1. Return on Assets
Independence of audit committee 5. Firm Age 6. Firm 2. Return on Equity
Size 7. Firm Leverage 8. Firm Growth Indicators.

Source: Author

1.2. Study hypotheses

H1: Board size impacts the Firm Performance

H2: Ownership structure impacts the Firm Performance
H3: CEO Duality impacts Firm Performance
H4: Independence of Audit Committee impacts the Firm Performance
H5: Firm’s Age impacts the Firm Performance
H6: Firm’s Size impacts the Firm Performance
H7: Firm Leverage impacts Firm Performance
H8: Firm’s Return on Assets impacts the Firm Performance

2. Literature review

Firm performance is dependent on the alignment of the shareholders (as principal) interest and
the interest of managers (as agent) within the firm, as contended by the agency theory (Bussin
et. al., 2023). Any misalignment between the interest of principals and agents results in higher
agency costs (Amin et. al., 2022). The incurrence of agency cost does not guarantee a perfect
alignment, rather it is an attempt to keep the alignment (Tang, 2022). Agency theory contends
the same argument, and is considered one of the landmark theories, linking form performance
with the alignment between the interest of managers and the principals.

Resource dependence theory is the same context contends the power of firm on its externa
environment is pivotal for establishing a competitive advantage for the firm (Zhang et. al.,
2022). The external environment for instance the consumers, suppliers, and the board of
directors are contingencies of the organizational power (Gebhardt et. al., 2022) The theory
argues that organization do have dependence on resources. The organizational environment is
the originator of these resources. This environment contains the internal and environment, and
actors within such environment.

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Though the alignment of interest, and dependence on resources is relevant, nevertheless one
tends to take into account the stakeholders theory. The theory contends that the inter
connectedness of the relationships between larger set of stakeholders, rather than just the
shareholder, creates more value (Poletti & Martinez, 2022). These stakeholders include the
shareholders, employees, customers, suppliers, lenders, communities, society, and any others
who take interest in the firm. The theory argues that a firm must diligently work to cater for
the interests of a larger set of stakeholders to create more value in the future (Ain et. al., 2022).

These theories do provide a theoretical underpinning for this study, but the definition of
corporate governance, and operationalization of construct in context of the unit of analysis
provides the way forward for an issue/controversy at hand. To address the same, this study has
taken into account eight indicators of the corporate governance, namely, board size, ownership
structure, CEO duality, independence of audit committee, firm size, firm age, firm leverage,
and firm growth. These indicators have been studied for their ability to impact the firm
performance, which has been factored as return of assets and return on equity. These indicators
along with the operational meaning of the corporate governance are discussed in the following
paras.

At average large board size is found to be less effective in resolving the agency issues effecting
the firm performance, as compared to the lean board size (Disli et. al, 2022). The larger board
size may be constituted for equitable representation, but the effectiveness and efficiency of the
board for enhancing the firm performance goes in the backdrop (Ria, 2023). The choice
between creating an effective board size or a representative board size is never an easy one.
Equitable representation is often considered as collective wisdom, which may or may not result
in effective to create more value but is usually consensual (Marquez et. al., 2022).

Ownership structure may be defined as the distribution of equity by identity of the equity
owners, in addition to the distribution of equity with regards to capital and voting rights
(Rojahn & Zechser, 2022). The concentration of ownership in fewer hands, like many in
Pakistan, where controlling percentage of shares is kept within the family, results in a family
lead decision, rather than the financial objective (Miloud, 2022). There are arguments on both
sides of the ownership structure and concentration. This study has studied the effect of
ownership structure on the firm performance.

Independence of audit committee plays an important role in determining performance of a firm

(Lutfi et. al., 2022). This independence is pivotal for preventing the insiders from influencing
the work of independent third-party auditors, and the work of oversight committee (Rahman &
Ali, 2022). The importance of the audit committee’s independence needs not to be undermined,
as the audit committee does impact the board’s decisions and plans (Shrivastav, 2022). The
board’s understanding of the audit committee’s roles and responsibilities may help the firm in
achieving its desired performance (Buallay & Al-Ajmi, 2020). This performance may not only
be kept restricted to achieving the target growth and profit, but also the market position, better
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compliance towards the code of corporate governance, corporate citizenship, and harmony
among various stakeholders.

The firm size means the scale of volume or operations produced by a single firm (Zuhroh,
2019). Firm size is usually categorized as small, medium, and large. The firm size effect, known
as to be the empirical evidence that the risk-adjusted returns are larger for small firms than the
large ones, does have its place in the literature about corporate governance. It is important to
study the firm size as it significantly affects the profitability and efficiency of the firm
(Sondakh, 2019). Firm size effects the firm’ financial performance positively when proxied by
the return on assets (Husna & Satria, 2019). It may also indicate the rate of growth within a
firm in terms of its sales volume, assets, and employees.

A firm’ age is the length of time in years, a firm has been in existence, although some believe
that the existence is to begin from the date of firm’s listing on a recognized exchange (Younis
& Sundarakani, 2020). Firm age has been an important determinant of the firm’s performance,
and the argument exists on both sides. Some studies tend to find the convex relationship
between firm’s age and its profitability, suggesting that firms tend to perform less better with
age (Ardito et. al., 2019). Others suggest the creation of organizational experience as the firm
ages. This experience tends to handle the untoward situations better as compared to the young
firms (Ayuba et. al., 2019). Some argue that firm tends to perform better as it gets experienced.
It gets to now its strengths and weaknesses better, which in turn yield a better profitability
(Almoneef & Samontaray, 2019). It is also argued that the young firms induce effective
learning, which helps them grow better and increase performance over time (Chatterjee et. al.,
2021).

Firm’s leverage has been a long-debated indicator for firm value and performance, as capital
structure is one of the traditionally researched areas. Even the test books present views on both
sides, where some argue that capital structure effects the firm value, while other present results
for the opposite, that it doesn’t. The financial leverage indicates the amount of debt in firm’s
assets or its comparison with the amount of shareholders’ equity in the firm (Slehat et.al.,
2020). Financial leverage is an important indicator for the firm’s debt burden, while the
supplementary ratios / information signifies the firm ability to retire the debt (Ibrahim & Isiaka,
2020).

Growth of a firm occurs when it grows, which is usually expressed in terms of increase is sales,
profit, employment, value addition etc. It also involves the diversification of firm into the new
markets occurring through internationalization or acquisitions (Mehmood et. al., 2019). It is
important to differentiate the firm growth from the firm size, as the later means the financial
size of a firm expressed in suitable terms, while the growth refers to the rate of increase in the
size (Sohl et. al., 2020). Pertinent to mention that firms tend to change size, cost structure, and
capital structure according to the state of economy, though the aim is the enhance performance,
value, and profitability (Bodlaj et. al., 2020).
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Firm performance may be referred as how well or poor firm performs over a period (Bhagat &
Bolton, 2019). A firm performing good brings long-term gains to its stakeholders, in addition
of generating economic opportunities and financial propositions (Ahdal et. al., 2020). Such a
firm would also enhance return to its employees, produce quality products, allow fair
competition, and do value addition to the business sector it operates in. There are many
indicators of measuring the firm performance including the revenue, return, profitability,
market share, cash flow, values addition etc. This study has taken a single indictor, i.e., the
return, and to be specific, the return on assets, and return on equity only.

Return on equity and return on assets are a few of the established measures of evaluating the
firm performance. Both these measures are based on the financial data reported in financial
statements of a firm. Being accounting information, this information is based on accounting
convention of prudence, conservatism, timeliness, measurement, and substance over form.
Return on equity is computed by dividing the net income attributable to common shareholders
by the average equity of the firm during the year. While the return on assets is computed
through dividing the operating income by average assets of firm during the year.

3. Methodology

Though there are many indicators in total, this study has taken the board size (BS), ownership
structure (OS), CEO duality (CD), independence of audit committee (IC), firm size (FS), firm
age (FA), firm leverage (FL), and firm growth (FG) as the indictors of corporate governance
(CG). The impact of these indicators has been observed of the firm performance (FP), which
has been operationalized into return of assets (RA) and return on equity (RE). Pakistan stock
exchange (PSX) has been used as the unit of analysis for this study, where 100 public listed
firm from non-financial sector have been studied for a period 2013-2022 to observe the impact
of corporate governance on the firm performance.

A sample of 100 publicly listed firm on PSX, from the non-financial sector has been taken.
Data for a period of nine years, i.e., 2013-2022 has been gathered round the indicators of
corporate governance (CG), and the firm performance (FP). The CG has been operationalized
as the board size (BS), ownership structure (OS), CEO duality (CD), independence of audit
committee (IC), firm size (FS), firm age (FA), firm leverage (FL), and firm growth (FG). While
the FP has been operationalized as return on assets (RA) and return on equity (RE).

There are 100 numbers (N) of cross-sections and 9 are time intervals (T), containing both cross
sections and time series, thus the panel data having (N×T) 900 observations. Initially, Phillips
Peron, Levin Lin and Chu test are used to confirm the absence of the panel roots in the data at
5% level of significance. After this panel data model are being employed to find out the
relationship between the dependent and independent variable. Firstly, the stationary test is
performed to confirm the absence of unit root in the data. Therefore, the Phillips Peron test, the
Levin Lin test, and the Chu test are used to confirm the absence of the panel roots in the data
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at 5% level of significance. Secondly, the first model that is employed for the empirical analysis
is Pooled OLS can be stated by the equation given below:

ϒit =άi + ß Xit + μit

The above equation indicates the simple model of pooled regression in which ϒ is dependent
variables for i cross section at a time period t, and X is the indicator of the independent
variables. To capture the diversification effect, it is better to adopt fixed or random effect
model, to be chosen on the basis of Haussmann Test. However, between choosing the effect
and common models, F-test and Bruesch Pagon test is employed. Hypothesis of Haussmann
Test can be illustrated as:

H0: Random Effect Model is Appropriate (Reject if Prob<0.05)

H1: Fixed Effect Model is Appropriate

Equation for the Fixed Effect Model with Fixed Cross-Sections can be given as:

ϒit =άi + ß Xit + Fi + μit

Fi captures the firms’ specific effect with fixed cross-sectional effect. However, random mean
effect equation can be given as:

ϒit =άi + ß Xit + εi + μit

4. Analysis, findings, and discussion

To analyze the relationship between the FP and CG, three different models, i.e., pooled,
random, and fixed effect are after confirming the absence of unit root in the series. In the first
equation returns on assets has taken as the indicator of the firms’ performance. The empirical
findings under all three models are being given in the table 2. In Pooled OLS it is being
examined that board structure, and ownership structure are negatively related with the firm
performance as RA, whereas all other variables are positively related with the firm
performance. Moreover, CEO duality, independence of audit committee, and firm leverage are
significantly related with the firms’ performance. The results suggests that the CEO duality
increases the firm performance by 5.6 units, independent of audit committee increase the firm
performance by 12 units, and one unit increase in leverages increase the firm performance by
.02 units. However, there is 28% variation in dependent variable is due to the independent
variable, the value of Durbin Watson suggests no auto-correlation and the model is overall
good fit.

Haussmann test suggests acceptance of the null hypothesis which suggests the appropriation
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of the random effect model. Meaning there by that the board structure is negatively related with
the firm performance, whereas all other independent variables are positively related with firms’
performance. However, the independence of audit committee, and firm leverage is significantly
related with the firm performance. Independence of audit committee increases the firm
performance by 12.3 units and one unit increase in leverages increase the firm performance by
0.02 units. Moreover, there is 28% variation in the dependent variable due to independent
variables. Durbin Watson test exhibits the absence of auto-correlation, suggesting that the
overall model is a good fit.

Table 1: Impact of corporate governance indicators on returns on assets

Variables Pooled OLS Random Effect Fixed Effect
Coefficient t-Stats Coefficient t-Stats Coefficient t-Stats
C -11.89 -0.62 -14.85 -0.66 -50.53 -1.10
BS -0.44 -0.43 -0.07 -0.06 2.95 1.29
OS -0.67 -0.34 -1.18 -0.51 -6.99 -1.36
CD 5.59 2.03* 5.13 1.60 -0.41 -0.07
IC 12.06 4.19* 12.29 3.62* 11.71 1.34
FA 0.00 -0.65 0.00 -0.71 0.00 -1.93
FS 1.70 0.89 1.89 0.84 7.19 1.43
FL 0.02 17.56* 0.02 17.77* 0.02 17.26*
FG 0.01 0.66 0.02 0.75 0.02 0.92

R-Square 0.28 0.28 0.40

D.W. 1.93 2.09 2.27
F-Statistics 43.91 43.21 4.93
H Test 0.33

In the second part, relationship between the independent variables, and the firm performance
as RE, has been presented under three different panel data models after confirming the absence
of unit roots in the series. The table 2.2 suggests the empirical results as: In Pooled OLS, all
the independent variables are positively related with RE, except the ownership structure and
the firm size. However, only the firm size is significantly related with firms’ performance at
5% level of significance. One unit increase in size decreases the firm performance by .01 units.
There is only 1% variation in the dependent variable that is due to independent variables, there
is auto-correlation and the model is not a good fit.

Haussmann test suggests the acceptance of the alternative hypothesis, provided that the fixed
effect model is more appropriate, where effect along the cross sections is being analyzed.
Results show that the ownership structure, CEO duality, firm size, and firm leverage are
negatively related with the firm performance. Moreover, ownership structure, firm growth, firm
size, and firm leverage are significantly related with firm performance. Family ownership
decreases the returns on equity by 81 units. One unit increase in growth (sales growth) increases
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the return on equity by 80.82 units. One unit increase in size of the firm decreases the returns
on equity by 0.01 units. One unit increase in leverages decreases the returns on equity by 0.02
units. Moreover, only 15% variation in the dependent variable is due to the independent
variable. Model is overall good fit and there is no auto correlation.

Table 2: Impact of corporate governance indicators on returns on equity

Variables Pooled OLS Random Effect Fixed Effect
Coefficient t-Stats Coefficient t-Stats Coefficient t-Stats
C 5.00 0.05 -0.93 -0.01 -603.91 -2.45
BS 0.18 0.03 0.39 0.07 14.32 1.17
OS -3.77 -0.36 -4.51 -0.43 -81.64 -2.96*
CD 22.25 1.53 22.12 1.50 -5.33 -0.16
IA 17.27 1.13 17.27 1.12 4.57 0.10
FL 0.00 -0.72 0.00 -0.73 -0.02 -2.30*
FG 0.02 0.00 0.62 0.06 80.82 3.00*
FS -0.01 -2.72* -0.01 -2.74* -0.01 -2.41*
FA 0.02 0.21 0.03 0.22 0.05 0.44

R-Square 0.01 0.01 0.15

D.W. 1.31 1.32 2.00
F-Statistics 1.38 1.37 2.26
H-Test 0.0008

5. Conclusion

In light the findings, it is concluded that the indicators of corporate governance have varying
impact on RA and RE. For RA, the independence of audit committee, and firm leverage
significantly influence the RA. For RE, the ownership structure, firm leverage, firm growth,
and firm size significantly influence the RE. This contrast reveals an interesting combination
of the predictor for the firm performance which has been operationalized as RA and RE. This
poses an important question to the board of directors where they can decide between
maximizing their personal gains as RE, or maximize the return for the firm RA. Although
increase in RA is likely to result in the increase of RE, but it might involve a lag which the
board of director may or may not be willing to allow. Nevertheless, these findings distinguish
the predictors of the firm performance, with the standpoint of return on assets and return on
equity.

This study’s findings are useful for the owners and managers of the non-financial sector public
limited companies listed on PSX. These findings help the owners and managers to align their
interest, hence reducing the agency costs and maximizing the returns for the firm. These results
are also beneficial for the investors, suppliers, debt holders and other stakeholders for making
decisions regarding investment.
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These findings assist in improving the abilities of the corporate regulators to regulate the firms
in a transparent manner. These also help the managers to improve their short term and long-
term decision makings for financial and managerial strategies. The study may help in
minimization of costs regarding corporate governance and increases the corporate performance
of companies. These findings may also be advantageous for the future studies researchers in
the area of improving the firm performance and corporate regulatory framework.

6. Limitations and recommendation for the future research

This study has been kept limited to the non-financial sector firm listed on PSX. Future studies
are recommended to consider the financial sector firms listed on PSX, and for that matter other
financial exchanges in the region may also be considered. Furthermore, this study has taken
only eight indicators of the corporate governance index. The index contains close to two dozen
indicators. Future studies may consider taking additional / other indicators into account for
studying the impact of corporate governance indicators on the firm performance. Also, the firm
performance has been operationalized as return on assets and return on equity for the purpose
of this study. Market price of share, being reflective of the firm performance may also be
considered in the future studies. In addition, this study has taken 2013-2022 as the study period,
which did contain the effect of pandemic, floods, and political turbulence in Pakistan. To rule
out any likely effect of abnormalities, any suitable study period may also be taken into account
by the future studies.

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Declaration of conflict of interest

The author(s) declared no potential conflicts of interest(s) with respect to the research, authorship,
and/or publication of this article.

Funding

The author(s) received no financial support for the research, authorship and/or publication of this
article.

ORCID iD

Khalid Mumtaz Khan https://orcid.org/0000-0003-3735-8383

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