Capital Structure and Profitability: A Critical Analysis of Quoted Manufacturing Companies in Nigeria

Aransiola Solomon Yinka^*, Aransiola Oluwadetan

Department of Accounting and Finance, Crawford University, Faith City, Igbesa, Ogun State, Nigeria

Abstract

Capital structure decision is a vital one in any organisation that is striving to achieve profitability. Therefore, the main objective of this study is to examine the effect of capital structure on performance of quoted manufacturing companies in Nigeria. In achieving this, Secondary data source was employed; data was collected from the Nigerian stock exchange factbook and the annual report of the selected companies. Due to the nature of the study, Panel data analysis was used. Both descriptive and inferential methods were used to analyse the data collected. Correlation analysis was used to determine the relationship between the variables while regression analysis was used to determine how the independent variable affects the dependent variable. The study established that there is a negative relationship between capital structure and profitability performance of quoted manufacturing companies in Nigeria. Recommendations were made that: Performance standards should be established and communicated to the investors (members of the companies), the optimal capital structure which lowers cost of capital and reduce risk associated with debt finance should be pursued, and inadequate capital to achieve firm’s financial performance might also pose a challenge. Therefore, banks, other financial institutions and government should promote facilities to increase companies’ profitability performance.

Keywords

Capital Structure, Profitability, Performance, Quoted, and Manufacturing Companies

Received:April 8, 2015
Accepted: May 15, 2015
Published online: June 23, 2015

@ 2015 The Authors. Published by American Institute of Science. This Open Access article is under the CC BY-NC license. http://creativecommons.org/licenses/by-nc/4.0/

1. Introduction

The capital structure decision is the vital one since the profitability of an enterprise is directly affected by such decision. Hence, proper care and attention need to be given while determining the capital structure decision. In the statement of affairs of an enterprise, the overall position of the enterprise regarding all kinds of assets, liabilities are shown. Capital is a vital part of that statement (hereafter called comprehensive financial statement).

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).  

Hence, the higher the debt ratio, the greater the risk, and thus higher the interest rate will be. At the same time, rising interest rates overwhelm the tax advantages of debt. If the firm falls on hard times and if it’s operating income is insufficient to cover interest charges, then stockholders will have to make up the short fall, and if they can’t, the firm may be forced into bankruptcy. Good times may be just around the corner. But too much debt can keep the company wipe out shareholders in the process (Azhagaiah and Gavoury, 2011). 

The relationship between capital structure decisions and firm value has been extensively investigated in the past few decades. Capital structure could have two effects; according to Desai (2007) firms of the same risk class could possibly have higher cost of capital with higher leverage. Second, capital structure may affect the valuation of the firm, with more leveraged firms, being riskier and consequently valued lower than the less leveraged firms. Ogebe, Patrick; Ogebe, Joseph and Alewi, Kemi (2013).

If capital structure is not irrelevant, then there is also another thing to consider: the interaction between financing and investment. In order to try to distinguish the effects of various determinants on capital structure, it is assumed that the investment decision is held constant. The choice of capital structure of a firm is determined by a number of factors which include the market forces, type of industry, internal policies of the firm, size of the firm, profitability, corporate tax and bankruptcy costs. Ogebe et al

Capital structure decision is the mix of debt and equity that a company uses to finance its business (Damodaran, 2001). Capital structure may affect the valuation of the firm, with more leveraged firms, being riskier and consequently valued lower than the less leveraged firms. If the manager of a firm has the shareholders' wealth maximization as his objective, then capital structure is an important decision, for it could lead to an optimal financing mix which maximizes the market price per share of the firm.

Of all the aspects of capital investment decision, capital structure decision is the vital one. Since the profitability of an enterprise is directly affected by such decision. There could be hundreds of options but to decide which option is best in firms interest in a particular scenario needs to have deep insight in the field of finance as use of more proportion of debt in the capital structure can be effective as its less costly than equity but it also has some limitations because after a certain limit it affects company’s leverage. Therefore a balance needs to be maintained.

In Nigeria, most corporate decisions are dictated by managers. Equity issues are often favoured over debt in spite of debt being a cheaper source of fund; even where debts are employed, it is usually on the short term basis. This could be as a result of the manager’s tendency to protect his human capital and avoid the performance pressure associated with debt commitment. More often, when debts are issued voluntarily, particularly long term debt, it is used as an ant- take- over device against the challenge of potential corporate rider. The corporate sector in the country is characterized by a large number of firms operating in a largely deregulated and increasingly competitive environment.

According to Bierman and Smidt and Guthman and Donglalls capital structure is the relative proportion of the various kinds of securities a company has used. The opinions of Taylor and Venhorne regarding capital structure is that is the total sum of outstanding long-term securities, both equity and debt. Weston and Bringham(1978) define it as the permanent financing of the firm represented by long-term debt plus preferred stock and net worth. Though there are different views about the total nature of ‘capital structure’ it is obvious  that  majority agreed about the common items, i.e. total of equity and long- term debt which represent the permanent source of financing of a company. Therefore, capital structure may be defined as the permanent source of capital in the form of long- term debt, preference shares, ordinary shares, reserve and surplus.

Most studies found a negative relationship between profitability and leverage. Within this framework, Titman& Wessels (1988) contend that firms with high profit levels, all things being equal, would maintain relatively lower debt levels since they can realize such funds from internal sources.

There have been various schools of thoughts on the relevance of capital structure to a firm’s performance in the developed countries, In Nigeria also studies have been conducted on this particular subjec matter but it is yet to be established the actual effect that capital structure has on the ability of quoted companies to achieve its profitability performance objective.

2. Methodology

Out of the forty- six (46) Quoted manufacturing companies according to the classification of companies in Nigeria by the stock exchange commission, ten (10) companies were purposively selected. Therefore, secondary annual data coverage of ten years (2008 – 2013) has been collected from the ten (10) different quoted manufacturing companies selected for the empirical analysis in this study. The two main methods of analysis were used in the course of this study.

a.   Descriptive Analysis: - This is the collection of large data with the aim of analysing them.

b.   The second approach which is quantitative techniques include tables and test for the hypotheses, inferential statistics specifically regression analysis method was used in order to determine the effect of capital structure on profitability performance of selected quoted companies in Nigeria. To do this, a software package E-views was used to perform the regression.

For the purpose of this study, two set of variables are considered namely the independent and dependent variables. The independent variable is capital structure and the dependent variable is profitability performance. The profitability performance is measured using profit before tax, profit, and profit after tax. The independent variable is measured by the total asset, equity, total asset over equity.

3. Results and Discussions

3.1. Data Presentation

Table 1. Presentation of the data of selected manufacturing companies.

Source: Author’s computation from Data gotten from Nigeria Stock Exchange Factbook 2013 edition.

Table 2. Descriptive Statistic of Dependent and independent variables.

Source: Author’s computation 2014.

The descriptive statistics show that over the period under study, the financial performance ratios measured by return on assets averaged 8%. The leverage ratio stood at 10.42. This is an indication that approximately 104% of total capital in the listed ten (10) manufacturing firms is represented by debt.

Here, the maximum values for leverage ratio and ROA are 69634%, 43% respectively. On the other side, the minimum values for leverage ratio and ROA are -912%, and -20% respectively confirming presence of loss performance. The standard deviation shows the level of risk involved in choice of financing which is high at 73.70.This also confirms that the portion of debt in the capital structure is high.

The mean of ROA is at 9% this implies that for every N100 worth of asset of the companies under this study, return is N9, pointing out low accounting performance for the firms

Standard deviation measures level of risk and in this case leverage of 73.70 shows debt financing is high resulting in higher level of risk. When compared with ROA of 11% the level of risk indicates other factors aside capital structure plays a part in performance.

3.2. Correlation Analysis

Correlation is describes the strength of relationship between two variables. In this study the correlation co-efficient analysis is under taken to find out the relationship between capital structure and financial performance. It can be said that what relationship exist among variables. Here, dependent variable financial performance is correlated with independent variable capital structure. Correlation analysis is performed to find out the relationship between variables; Capital structure and ROA.

Table 3. Correlation matrix between capital structure and ROA.

Source: Author’s computation 2014.

The above table illustrates the relationship among leverage ratio and Return on assets. The correlation value between leverage and Return on Asset is r = (-0.134) this shows that there is negative relationship between capital structure and Return on Asset of the ten companies analyzed in this study.

3.3. Regression Analysis

Regression analysis is carried out to test the impact of capital structure on financial performance. Here capital structure is the independent variable and financial performance is the dependent variable. From these independent and dependent variables, the following relationships are formulated. Financial performance of the manufacturing firms is dependent upon the capital structure. It is represented as follows;

Which shows performance is the function of capital structure.

Where;

FP = Financial performance

CS = Capital Structure

Here, financial performance is measured with the help of two ratios return on equity and return on assets. Capital structure is measured through leverage ratio. Therefore, the regression model will be formulated in the following manner;

ROA = â0 + â1x1                               (1)

Where;

X1 = Leverage ratio

â0 = Constant

ROA = Return on Assets

Table 4. Regression model for capital structure and ROA.

Source: Author’s computation 2014.

Here, R2 value is computed to identify the impact of leverage ratio on return on assets. The R2 value is 0.016. This means leverage ratio contributed to determine return on assets by 1.6%. The remaining 98.4% is influenced by other factors which are not considered for this study.

3.4. Hypothesis Testing

H0: capital structure has no significant effect on profitability of a manufacturing firm.

H1: capital structure has a significant effect on the profitability of a manufacturing firm

According to the regression analysis, it showed that the r2 value between leverage and ROA is 0.016 with 95% level of confidence. Therefore, leverage has no significance impact on ROA. Here, H0 is accepted and H1 is rejected. H0: capital structure has no significant relationship with profitability of a manufacturing firm.

H1: capital structure has a significant relationship with the profitability of a manufacturing firm

From the study, correlation analysis showed that the correlation between leverage and ROE is (-0.134). Therefore, there is no significance relationship between leverage and ROA. Here, H0 is accepted and H1 rejected.

4. Conclusion

The aim of this study is to examine the effect of capital structure on profitability performance of quoted manufacturing firms. The study shows that there is a negative or inverse relationship between the leverage ratio and the return on asset. This means that an increase in capital structure will cause a decrease in profitability performance and vice versa. The magnitude of the contributory effect of leverage ratio on the change in return on asset is very low with a regressive value of 0.016. This therefore implies that the rate of effect is 1.6% leaving the remaining 98.4% to other contributory factors.

The descriptive statistics show that over the period under study, there is an indication that approximately 104% of total capital in the listed ten (10) manufacturing firms is represented by debt. The standard deviation shows the level of risk involved in choice of financing which is high. It was also confirmed that the portion of debt in the capital structure is high.

The mean of ROA is at 9%, this implies that for every N100 worth of asset of the companies under this study, return is N9, pointing out low accounting performance for the firms.

Two hypotheses were stated and tested in this study, capital structure has no significant effect on profitability of a manufacturing firm and capital structure has a significant effect on profitability of a manufacturing firm. According to the regression analysis and correlation analysis, capital structure has no significant relationship on the profitability of manufacturing firms.

As much as capital structure decision is the vital one since the profitability of an enterprise is directly affected by such decision. There are other factors that form a larger part of the contributory effect to the rise, stability or fall of the profitability of a firm.

Based on the findings of this study, capital structure has effect on the profitability performance of quoted manufacturing companies however, the effect is not significant. The study also showed that there are other contributory factors to the change in the profitability of a firm.

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