ABSTRACT
A high number of quoted firms have registered declining financial performance in the recent years resulting to financial difficulties contrary to stakeholders’ expectations and adversely affecting the economic growth of the Kenyan economy. Financial structure choice and its impact on financial performance remains a great dilemma to all stakeholders. This study investigated the effect of financial structure on financial performance of selected firms listed at Nairobi Securities Exchange, Kenya. Specifically, the study investigated the effect of leverage, liquidity and equity on financial performance. In addition, the study evaluated the moderating effect of firm size on the relationship between financial structure and financial performance of selected firms listed at NSE, Kenya. The study adopted positivist philosophy as it focused on objectivity and fits a quantitative study with the objective of testing hypotheses. Explanatory research design was employed in this study due to the nature of the problem and available quantitative data. Multivariate tests using panel data model examined the effects of independent variables on firm’s financial performance. The target population of the study comprised of all 30 firms listed on the NSE, between years 2007 to 2015 drawn from seven selected sectors of the economy which met the selection criteria. A census of the 30 firms was done and data collected for the 30 companies for the period 2007 – 2015. The study utilised secondary panel data contained in the annual reports and financial statements of selected companies. Various diagnostic tests including Auto-correlation test, Normality test, Heteroscedasticity test, Unit root test and Test for pooling were carried out. Breach-Pagan Lagrange multiplier (LM) test was used showing that there were no panel effects (implying that ordinary least square should be used (pooling). Therefore, the data was pooled. The study used descriptive statistics, correlation analysis and panel linear multiple regression analysis. Regression coefficients were used to test for significance using t-statistic at 5% level of significance and conclusions drawn. The coefficient of determination (R2) was used to rank explanatory variables’ contribution to the response variable. The study found that Leverage, Liquidity and Owners Equity had significant positive effect on financial performance of selected companies listed at NSE, Kenya, while firm size had positive and significant moderating effect on the relationship between financial structure and financial performance. The overall moderating effect of firm size on the relationship between financial structure and financial performance increased by 7.7% after incorporating the moderator which explained 91.6% of changes in financial performance compared with 83.9% without the moderator. The study concluded that leverage, liquidity and owners’ equity had positive and significant effect on financial performance and that the use of various components of financial structure jointly enhanced the financial structure’s power to explain the variations in financial performance. The study contributed to the financial structure literature by providing evidence of the effect of Leverage, Owners’ Equity and Liquidity on financial performance of firms listed in NSE, Kenya for the period 2007-2015. The study recommended that managers of the selected firms listed at NSE, Kenya could utilize the various sources of finance since financial structure has a positive effect on the financial performance of the listed firms with leverage making the highest contribution to financial performance.
CHAPTER ONE: INTRODUCTION
Background of the study
Listed firms contribute in many ways to the Kenyan economy. They provide employment in the firms thus reducing unemployment problems. They pay taxes to the government which is utilized to provide the necessary products and services to the citizen of the country and also contribute to the research and development thus increasing innovation. Therefore, firms’ financial performance is critical if they are to fulfill their stakeholders interest.
Firm’s financial performance refers to a firm’s ability to generate new resources from day to day operations over a given period (Bora, 2008). It involves enhancing shareholders’ wealth and profit making which are among the major objectives of a firm (Pandey, 2005). Financial ratios derived from the balance sheet and income statement and also from data on stock market prices, are used to measure how better off a shareholder has become over time (Berger & Patti, 2002). The growth in firms’ sales, the improvement in their profit margin, their capital investment decisions and capital structure decisions mainly influence the shareholder’s wealth (Arnott & Asness, 2003).
Firm’s financial performance further plays the role of increasing the market value of a firm in addition to leading towards the growth of the whole industry and ultimately towards the overall prosperity of the economy. This explains why in corporate finance literature, assessing the determinants of financial performance of listed financial firms has gained great importance despite it having received little attention particularly in
developing economies (Ahmed, Zeng, Sinha, Flavell, & Massoumi, 2011). These companies provide the mechanism for risk transfer and channeling the funds in an appropriate way to support the business activities in the economy.
Financing decisions result to some form of financial structure. Financing choices are major corporate decisions because an optimal capital structure, representing the corporate financing mix, can maximize the market share price and the value of the company. Modigliani and Miller (1958) demonstrated the irrelevance of capital structure in firm value, although the assumption is valuable only in perfect market conditions, where all investors have free access to market information, there are zero transaction costs and no tax difference between dividends and capital gains. However, real economies are far from being perfect and thus many financing decisions theories were developed over time in order to demonstrate the purpose of capital mix and its role in company value and financial performance. After the irrelevance theory, Modigliani and Miller (1963) revised the conditions and explained that interest expenses are tax deductible, and therefore the value of the firm should increase with higher debt ratios. Over time the capital structure literature developed and researchers found many variables that influence both financing decisions and financial performance.
According to Cole, Yan and Hemley (2015), capital structure theory and its relationship to corporate performance has been a controversial issue in corporate finance over the years. Many persons argue that companies should use third-party capital as the main source of financing for the tax benefit, since the interest paid on the debt is deductible from the tax payable. They can increase net profit in the period.
However, the problem of financing with third-party capital is to increase the company’s debt, which increases its risk. On the other hand, although equity capital financing is not subject to this situation, it does not obtain the tax benefits provided by the financing with third-party capital, since dividends do not deduct taxes. Shubita and Alsawalhah (2012) noted that it is difficult to determine the optimal financial structure of a firm as this entails analysis of their risk and profitability among other factors.
The financing decisions are also affected by the environments within which the firms operate and which exhibit high degree of instability. The period starting 2007 was characterised with a harsh economic climate because of the financial crisis that faced the world. Due to financial crisis of 2007, the supply of external capital was radically restricted and companies were forced to rely on internal sources. The high cost of borrowing and shallow financial deepening are major challenges facing firms in developing countries. Consequently, the capacity of business entities to undertake investments is directly affected by financial resources available (Fung & Wing, 2011). According to Cole et al. (2015), it may seem that the way in which a company chooses how its operations are financed is independent of its current performance. Modigliani and Miller (1958), when introducing studies on capital structure, concluded that the company’s value is independent of its capital structure, assuming markets are perfect.
Past studies on the relationship between financial structure and financial performance have concentrated on investigating the direct relationship between financial structure and financial performance of companies and mainly investigating individual component of financial structure at a time. However, authors documented different
results and explained various rationales in this respect. Some authors found positive leverage-performance relationship, while others believe conversely and described debt as negative connotation (Abor, 2010). Mwangi, Muathe and Kosimbei (2014) concluded that increased financial leverage has a negative effect on performance. According to O’Brien (2003), misleading conclusions can be made while studying variables’ direct relationship with financial performance. This applied for studies relating leverage, liquidity and Owners equity to financial performance where studies are done individually. This would also apply to this study if a direct financial structure-performance relationship is studied. It is argued that, contingency and situational factors result to contradictions and inconsistencies in the various studies that looked at the relationship between the various components of financial structure and performance (Jermias, 2008).
