The Effect of Capital Structure on Profitability of Financial Firms Listed at Nairobi Stock Exchange

Abstract

Capital is the financing for a business and is made up of, primarily, owners’ funding and funding from lenders. The combination of the sources of business funding is referred to, as the capital structure of that business. Capital structure is thus the mix of company’s long term debt, specific short term debt, common equity and preferred equity; that is, how a firm finances its overall operations and growth using different sources of funding. This is composed of equity (rights issue) and debt financing (credit market through corporate bonds etc). This research sought to investigate the effect of capital structure on profitability of financial firms listed at Nairobi Stock Exchange during the period 2008-2012. The success of financial institutions in Kenya’s dynamic business environment depend on their ability to effectively determine the optimum and appropriate capital mix that is necessary to ensure that the shareholders get returns. It is worth noting that financial institutions depend on their ability to identify, assess, monitor and manage risks in a sound and sophisticated way. In order to assess and manage risks, financial firms must have effective ways of determining the appropriate amount of capital that is necessary to absorb unexpected losses arising from their market, credit and operational risk exposures. The sector has recorded double-digit growth in profits for most of the past decade, when the economic growth has averaged at about five per cent. Factors such as amount of debt, the risks associated with indebtedness, interest rates and debt equity combination could affect the financial performance of firms. This research investigated the effect of capital structure on financial performance in relation to these factors. In respect of the above objectives of the study, data was collected by a review of documents, annual reports of the companies and the Nairobi Stock Exchange reports. Data collected was analysed using Statistical Packages for Social Sciences (SPSS) which gave descriptive analysis. The data was then be summarised and presented using tables. The study revealed that capital structure is inversely related to performance as revealed by the regression results of debt and return on equity. The results show that the mean values of debt/equity ratio and debt to total funds were 591.52% and 86.9% respectively. The mean value of debt/equity ratio suggests that debt is 5.915 times higher than equity capital. The debt/equity ratio is normally safe up to 2. It shows the fact that listed financial institutions in Kenya depend more on debt rather than equity capital. The mean value of debt to total funds ratio indicates 86.9% of the total capital of listed banks in Kenya is made up of debt. This has re-emphasized the fact that banks are highly levered institutions. The co-efficient values were found to be negative for the association between debt to equity and interest. This reveals that an increase in the level of debt finance increases the interest payments thus resulting in a decline in profitability. Arising from this observation it can be postulated that capital structure choice among listed financial firms support the pecking order theory that firms prefer raising capital, first from retained earnings, second from debt, and third from issuing new equity. The study noted that banks generally play a crucial role in the economic development of every country. One critical decision banks face is the debt-equity choice. Among others, this choice is necessary for the profit determination of firms. What this means is that banks that are able to make their financing decisions prudently would have a competitive advantage in the industry and make superior profits. However, it is essential to recognize that this decision can only be wisely taken if banks know how debt policy influences their profitability.