AN EVALUATION OF CAPITAL STRUCTURE AND PROFITABILITY OF BUSINESS ORGANISATIONS
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ABSTRACT
The capital structure decision is crucial for every business aiming to attain profitability. Therefore, the primary purpose of this study is to investigate the impact of capital structure on the performance of Nigerian publicly traded manufacturing companies. In order to accomplish this, secondary data sources were utilized; information was gathered from the Nigerian stock exchange fact book and the annual reports of the selected quoted companies. In this study, sample data was obtained from ten (10) randomly selected enterprises within these industries between 2010 and 2014, and their five-year financial statements were extracted and evaluated. The research employed three metrics of Return on Assets, namely, short-term debt (STD), total debt (TD), and growth size (E TA), in order to determine whether capital structure had a substantial impact on profitability. Using Fixed-effect estimation, Random-effect estimation, and the Pooled Regression Model, the study analyzed panel data. Two of the policies have a considerable negative influence on the profitability of manufacturing firms listed on the Nigeria Stock Exchange, while one has a large favorable effect. In order to enhance returns on equity, assets, and investment, the study suggests that the management of mentioned Nigerian manufacturing firms work very hard to optimize the capital structure of their quoted manufacturing enterprises. This can be accomplished by ensuring their capital structure is optimal.
FIRST PART
INTRODUCTION
1.1 CONTEXT FOR THE STUDY
Whether a firm is brand-new or established, it requires funds to conduct its operations, as success is impossible without them. The funds may be required for daily operations or business developments. This indicates the significance or necessity of capital in the firm; this fund is known as capital. Therefore, it represents a company’s financial liabilities.
This study examines the relationship between capital structure and profitability of several quoted Nigerian industrial enterprises. Capital structure is one of the most confusing questions in the literature on corporate finance (Brounen & Eichholtz, 2001). The term often refers to the combination of debt and equity that makes up a company’s overall capital. The debt-to-equity ratio is a strategic decision made by corporate managers. The capital structure decision is crucial since it directly influences the profitability of a business. Therefore, care and consideration must be taken when choosing capital structure.
Capital structure is the proportion of each type of debt and equity capital utilized by an enterprise. Numerous firms use debt into their capital structure due to its advantages. One of the advantages is that interest on debt is tax deductible, thereby reducing the tax liabilities of the affected entities. In addition, inability to meet an interest obligation can result in a financial decline. As a result of the repercussions associated with the usage of debt, the capital structure decisions of the financial managers are influenced by a multitude of factors. The variables include capital cost, debt capacity, cash flow, etc. In an enterprise’s statement of affairs, the enterprise’s overall position regarding all types of assets and liabilities is presented.
Capital is essential to this proposition. A company’s “capital structure” consists of equity shares, preferred shares, and long-term obligations. Regarding the optimal capital structure, careful consideration must be given. Companies with an unplanned capital structure may fail to utilise their funds efficiently. Consequently, it is becoming increasingly apparent that a company should manage its capital structure to maximize the use of cash and to be more adaptable to changing circumstances (Pandey, 2009). The relationship between capital structure and profitability has been extensively studied in the finance literature.
Capital structure is essential to comprehending how a firm is managed and financed, and it is simple to determine simply examining a company’s balance sheet. Capital structure refers to the relationship between a corporation’s assets and liabilities, including how the assets are financed and the amount of debt the company manages. The decision regarding financial structure is critical for businesses. The capital structure decision is significant due to the necessity to maximize firm returns and the effect such a selection has on a company’s ability to deal with its competitive environment. A company’s capital structure consists of a variety of instruments. In general, businesses can select from a variety of alternative financial arrangements. Firms can arrange lease financing, utilize warrants, issue convertible bonds, sign forward contracts, and trade bond swaps, for instance. Additionally, companies might issue thousands of separate securities in limitless permutations to enhance market value (Abhor, 2005, p.438).
Various hypotheses have been proposed to explain the capital structures of a company. Despite the theoretical allure of capital structure, financial management academics have been unable to identify a model for an optimal capital structure. Academics and practitioners have only been able to develop prescriptions for short-term objectives (Abor, 2005, p.438).
The relationship between profitability and capital structure is a two-way street. On the one hand, a firm’s profitability is an essential determinant of its capital structure, while on the other hand, changes in capital structure affect the firm’s underlying profits and risk, which are reflected in its market value.
The most crucial choice that all corporate managers must make is how to finance their companies’ long-term capital requirements. Capital structure refers to a company’s permanent financing, which consists mostly of stock and long-term liabilities and excludes all short-term credits. In order to identify the capital structure of a company organization, numerous criteria must emerge.
Financial managers consider these issues first when determining an acceptable capital structure for their company. Cost of capital, flotation expenses, firm size, government policies, and market conditions are some of the considerations. The mix of stock and debt has implications. The first is the debt-to-equity ratio, which is considered a risk indicator.
Particularly over the long term, a company’s profitability will determine whether it will continue to operate or not. Return on capital employed, return on equity, earnings per share, return on assets, net profit margin, and gross profit margin are typically used to measure profitability.
Since Modigliani and Miller demonstrated in 1958 that the capital structure decision of the firm is meaningless under frictionless markets and uniform expectations, capital structure has been a major problem in financial economics. By relaxing the assumptions and studying their consequences, theories attempt to discover if an optimal capital structure exists and, if so, what its potential determinants may be. The connection between capital structure decisions and business value has been intensively studied over the past several decades. Capital structure may have two consequences; according to Desai (2007), enterprises in the same risk class may incur a greater cost of capital if they have a larger leverage ratio. Second, capital structure may influence the valuation of the firm, with more leveraged enterprises being riskier and, as a result, being valued at a lower price than firms with less leverage. If the goal of the manager of a company is to maximize the wealth of its shareholders, then capital structure is a crucial decision, as it may lead to an optimal financing mix that maximizes the market price per share of the company.
Nigeria is a developing nation with a single stock exchange (Nigerian Stock Exchange NSE), but just a handful of branches throughout the nation, which accommodate approximately 260 securities. Similar to other developing economies, Nigeria’s capital structure remains mostly unexplored. On this topic, only a few studies exist, such as Salawu’s (2007) empirical investigation of the determinants of capital structure for 50 non-financial enterprises between 1999 and 2004. This study expanded on that of Salawu (2007) by incorporating exogenous variables, employing a longer time frame, and analyzing the impact of leverage from the previous year on leverage from the current year. (CBN report 2009)
1.2 RESEARCH PROBLEM
In order to finance their capital initiatives, the owners of a company will not want to lose control by issuing more shares to the general public. Instead, they borrow, which involves utilizing debt instruments such as debenture stock. These business owners should be aware that whether or not there is a profit, the debentures should settle their interest. Nobody can foretell the future with absolute accuracy; business booms and busts are equally possible. How can businesses effectively blend loan and equity funding to secure profitability?
The emergent nature of the Nigerian capital market with its inherent problems of inactive debt market, shallow nature of the market, buy and hold syndrome of Nigerian investors, etc., coupled with the unfavorable socio-political environment, causes Nigerian firms to rely more on the money market than the capital market for their funding needs. Consequently, the money market dominates Nigeria’s financial system.
The issue faced by businesses in Nigeria has more to do with funding, whether it be debt or equity capital. The issue of financing is so crucial that it has been highlighted as an urgent cause why businesses fail to launch or advance (Graham, 1996). Thus, enterprises in Nigeria must be able to finance their activities and expand over time if they are to play a growing and preeminent role in generating value added and profits.
The cascading implications of this anomaly cast doubt on the genuine relationship between capital structure and profitability of publicly traded Nigerian manufacturing enterprises. That is, whether the trade-off hypothesis, which supports a positive association, or the pecking order theory, which supports a negative relationship, is more appropriate. This study intends to investigate this relationship.
1.3 PURPOSE OF THE STUDY
This study aims to accomplish a number of objectives. The primary purpose of this research is as follows:
To determine the relationship between capital structure and profitability of Nigerian listed enterprises.
1.4 RESEARCH QUESTION
This research question translates the aims and will be answered using the generated empirical evidence.
The primary research topic that guides this study is as follows:
1) To what extent does capital structure affect the profitability of publicly traded Nigerian manufacturing companies?
1.5 STATEMENT OF HYPOTHESIS
To guide this study, the following hypotheses have been created.
There is no correlation between the capital structure and profitability of manufacturing enterprises in Nigeria, according to the null hypothesis.
1.6 SCOPE OF THE STUDY AND LIMITATIONS
This study examined the relationship between capital structure and the profitability of business organizations, despite the fact that capital structure has numerous effects on a firm, including profitability, share market value, and financial crisis. Some mentioned manufacturing enterprises in Nigeria were examined as a business entity.
This study is confined to ten quoted manufacturing firms in Nigeria; some of the other quoted listed firms investigated do not have comprehensive data of key variables owing to discontinuation of operation or issues with the Nigerian Stock Exchange (NSE) and Securities Exchange Commission (SEC). Financial, utility, and other highly regulated industries are excluded from the study to prevent any distortions in the results caused by industry-specific restrictions.
1.7 SIGNIFICANCE OF THE EXPERIENCE
The funding of a business is a crucial business choice. Managers of a company’s finances must determine whether to use more debt or more equity; whichever choice is made has consequences. Everyone should keep in mind that the primary purpose of every organization is to generate a profit, which this research will do through its findings:
To persuade corporate managers of the relationship between capital structure and the profitability of a company organization, and to enable them to make decisions in accordance with this understanding.
The statement will aid prospective investors in planning their capital structure in order to maximize profit.
Profitability is seen as a major factor in determining capital structure, a factor that includes bankruptcy costs, agency costs, taxes, and information asymmetry, among others.
The topic of capital structure has been extensively studied, but the study is relevant in the different time period and context to determine whether the evidence about the capital structure issue and its various elements are relevant to a given set of organizations during a given time period. Given this significance, the current study seeks to comprehend and investigate the capital structure and its effect on profitability of major enterprises in Nigeria, an important link that has not received much attention in the past.
This will be beneficial to the study endeavors of future scholars.
1.8 DEFINITION OF TERMS
Capital Structure: Capital structure as a means by which an organization finances its general operations through the use of alternative sources of money. It entails the combination of equity and debt.
Profitability is the gauge of a company’s entire earning capacity.
Profitability is a company’s key long-term objective for the development of its organization over the years.
Long-term assets: the value of a business’s property, equipment, and other capital resources. These are indicated on the balance sheet’s left side. Assets that are not expected to be converted into cash or allocated within one year of the date of the balance sheet.
Short-term assets are assets owned by a corporation for a period of one year or less. It consists of accounts receivable, cash at the bank, cash on hand, etc. Current assets demonstrate a company’s liquidity. These assets are spent within a year or during the operating cycle without disrupting the organization’s regular operations.
Long term obligations A long-term obligation is one that the corporation expects to pay over a period of longer than one year.
Short term liabilities: Liabilities that a corporation is obligated to pay within one year or less than one year utilizing assets that are conspicuous on the current balance sheet. The commitments that will be satisfied by short-term assets are referred to as short-term liabilities.
Return on equity is the amount of money returned to shareholders from their equity; it measures the success of the owner’s assets. Return on equity measures a company’s profitability by revealing how much profit it generates with the money shareholders have invested.
Financial leverage is the use of fixed-cost sources of capital, such as debt and preference capital, in addition to the owner’s equity in the capital structure.
Debt is a loan obtained from an outside source to finance a firm. It is repayable and receives a return in the form of interest on the outstanding loan balance.
It is a lasting investment in a business. A individual who invests in equity becomes a part-owner of the company. This is yet another way of long-term funding. It consists of the share capital, share premium, and reserves.
Listed Quoted Companies: A firm whose shares can be purchased or sold on a stock exchange; additionally, the company issuing the securities must meet the requirements of the exchanges on which it desires to trade.
AN EVALUATION OF CAPITAL STRUCTURE AND PROFITABILITY OF BUSINESS ORGANISATIONS
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