EVALUATION OF CAPITAL STRUCTURE AND PROFITABILITY OF BUSINESS ORGANISATIONS
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EVALUATION OF CAPITAL STRUCTURE AND PROFITABILITY OF BUSINESS ORGANISATIONS
ABSTRACT
The capital structure decision is critical in any organisation seeking to attain profitability. As a result, the primary goal of this research is to investigate the impact of capital structure on the performance of listed manufacturing companies in Nigeria.
To do this, secondary data sources were used; data was gathered from the Nigerian stock exchange fact book and the annual reports of the selected quoted companies.
In this study, sample data were obtained from ten (10) randomly selected enterprises in different industries between 2010 and 2014, and their financial statements for five years were retrieved and analysed.
The study used three Return on Assets measurements, namely short-term debt (STD), total debt (TD), and growth size (E_TA), to determine whether capital structure had a substantial effect on profitability.
The study used panel data analysis with fixed-effect estimation, random-effect estimation, and a pooled regression model. The empirical data clearly demonstrated that the two measures have a negative substantial influence on the profitability of manufacturing firms listed on the Nigeria Stock Exchange, while one has a favourable effect.
As a result, the study suggests that management of Nigerian quoted manufacturing firms work hard to optimise their capital structure in order to enhance returns on equity, assets, and investment. They can achieve this by ensuring that their capital structure is optimal.
Chapter one
INTRODUCTION
1.1 Background of the Study
Whether a business is young or established, it requires funding to carry out its operations, as no success can be achieved without it. The required funds could be for daily operations or corporate expansions. This tells us how vital or essential a fund is in the firm; this fund is referred to as capital, and it represents a company’s financial liabilities.
The purpose of this study is to investigate the relationship between capital structure and profitability in some Nigerian manufacturing enterprises that are publicly traded. Capital structure is one of the most perplexing topics in corporate finance research (Brounen & Eichholtz, 2001).
The concept is often stated as the combination of debt and equity that constitutes a firm’s total capital. Corporate management make strategic decisions about the debt-to-equity ratio.
The most important capital structure decision is one that directly affects an enterprise’s profitability. As a result, sufficient care and attention must be paid while making capital structure decisions.
A company’s capital structure refers to the proportion of each type of capital debt and equity. Debt is used in many organisations’ capital structures due to its benefits. One advantage is that interest on debt is tax deductible, lowering the tax liabilities of the organisations involved.
Furthermore, failing to pay an interest commitment might lead to financial difficulties. Because of the implications of debt utilisation, financial managers analyse a wide range of criteria when determining capital structure.
The factors are the cost of capital, debt capacity, and cash flow. Etc. The statement of affairs of an enterprise shows the enterprise’s overall situation in terms of all assets and liabilities.
Capital is a critical component of that proposition. The word “capital structure” refers to an enterprise’s combination of equity shares, preference shares, and long-term debt. When it comes to the optimal capital structure, caution must be exercised.
Companies with an unplanned capital structure may fail to make the most use of their funds. As a result, it is becoming increasingly clear that a company’s capital structure should be designed to maximise fund utilisation while also allowing for easier adaptation to changing conditions (Pandey, 2009). The relationship between capital structure and profitability has garnered a great deal of attention in the financial literature.
Capital structure is critical for understanding how a corporation is run and financed, and it may be easily assessed by reviewing a corporate balance sheet. Capital structure refers to the relationship between a company’s assets and liabilities, including how the assets are supported and how much debt the organisation manages.
The capital structure decision is critical for corporate organisations. The capital structure decision is crucial because enterprises must maximise their profits, and it has an impact on the firm’s ability to deal with its competitive environment.
A firm’s capital structure consists of a variety of instruments. Firms can choose from a variety of capital arrangements. Firms can, for example, arrange lease financing, use warrants
issue convertible bonds, enter into forward contracts, or trade bond swaps. Firms can also issue dozens of different securities in endless combinations to maximise overall market value (Abhor, 2005, p. 438).
Several ideas have been presented to explain a firm’s capital structures. Despite capital structure’s theoretical appeal, financial management experts have yet to develop an optimal capital structure model. Academics and practitioners have achieved the best results by prescribing short-term goals (Abor, 2005, p.438).
The relationship between profitability and capital structure is two-way. On the one hand, firm profitability is an essential predictor of capital structure; on the other hand, changes in capital structure have an impact on the firm’s underlying profits and risk, which is reflected in its value.
The most crucial decision that all business managers must make is how their companies’ long-term capital requirements should be met financially. A firm’s capital structure is its permanent financing
which is mostly made up of stock and long-term liability, excluding all short-term credits. Many elements must be considered while determining a company’s capital structure.
These are the variables that financial managers assess first when determining an acceptable capital structure for their organisation. Some of the criteria are the cost of capital, flotation expenses
firm size, government policies, and market conditions. The mix of debt and equity has some implications. The first is the debt-to-equity ratio, which is used to assess risk.
The profitability of any corporate organisation determines whether or not it will continue to operate, particularly in the long run. Profitability is typically calculated using return on capital employed, return on equity, earnings per share, return on assets, net profit margin, and gross profit margin.
Capital structure has been a prominent topic in financial economics since Modigliani and Miller demonstrated in 1958 that in frictionless markets with uniform expectations, the firm’s capital structure decision is unimportant. Theories strive to discover whether an optimal capital structure exists and, if so, what its determinants may be.
The relationship between capital structure decisions and business value has been intensively studied during the last few decades. According to Desai (2007), capital structure can have two effects: enterprises in the same risk class may have a higher cost of capital and more leverage.
Second, capital structure can affect corporate valuation, with more leveraged enterprises being riskier and so valued lower than less leveraged firms. If the manager of a firm’s goal is to maximise the wealth of its shareholders, capital structure is a significant decision because it can lead to an optimal financing mix that maximises the firm’s market price per share.
Nigeria is a developing country with a single stock market (the Nigerian Stock market, or NSE), but just a few branches across the country that accommodate approximately 260 securities. Like other developing economies, Nigeria’s capital structure is mostly unexplored.
There is little study on this topic; for example, Salawu (2007) conducted an empirical examination of the determinants of capital structure for 50 selected non-financial enterprises between 1999 and 2004.
This study expanded on Salawu’s (2007) findings by include exogenous variables, employing a longer time frame, and taking into account the impact of previous year’s leverage on current year’s. (CBN Report 2009)
1.2 RESEARCH PROBLEM.
The owners of a firm do not want to lose control of their company by issuing more shares to the public in order to fund capital projects. Instead, they borrow, which entails using debt instruments such as debenture stock.
These business owners should be aware that whether or not a profit is made, the debentures’ interest should be settled. Nobody can anticipate the future precisely;
there may be a company boom as well as a business slump. The issue therefore becomes how businesses might blend debt and equity funding to assure profitability.
The emergent nature of the Nigerian capital market, with its inherent problems of an inactive debt market, a shallow market, Nigerian investors’ buy and hold syndrome, and so on
combined with an unfavourable sociopolitical environment, causes firms in Nigeria to rely more on the money market than the capital market for their funding needs. As a result, the money market dominates Nigeria’s financial system.
The challenge for Nigerian enterprises is mainly about financing, namely whether to raise loan or equity capital. Finance is such an essential issue that it has been highlighted as a direct cause of businesses failing to start or advance (Graham, 1996).
Thus, enterprises in Nigeria must be able to finance their activities and grow over time if they are to play an increasing and dominant role in providing value added and money in the form of profits.
This aberration’s compounding consequences call into doubt the genuine relationship between capital structure and profitability of Nigerian listed industrial enterprises.
That is, whether the trade-off hypothesis supports a positive association or the pecking order theory supports a negative one. The study aims to investigate this relationship.
1.3 The purpose of the study
The current study aims to achieve a number of objectives. The primary goal of this research project is as follows:
Ø Determine the association between capital structure and profitability of listed enterprises in Nigeria.
1.4 RESEARCH QUESTION.
The aims are translated into this research question, which will be answered based on the empirical evidence provided.
The primary research question that guided this investigation is as follows:
1) How much does capital structure effect the profitability of listed Nigerian manufacturing companies?
1.5 Statement of Hypothesis
The following hypotheses have been proposed to guide this research.
Ho: There is no substantial association between capital structure and profitability among Nigerian manufacturing enterprises.
1.6 SCOPE AND LIMITS OF THE STUDY
Despite the fact that capital structure has a wide range of implications for a firm, including profitability, market value of shares, and financial crisis
this study focused on the relationship between capital structure and business profitability. Some publicly traded Nigerian manufacturing enterprises were investigated as business organisations.
This study is confined to ten quoted manufacturing companies in Nigeria; some of the other quoted listed firms investigated do not have complete data on important variables due to termination of operations or issues with the Nigerian Stock Exchange (NSE) and Securities Exchange Commission.
The analysis excludes the financial, utility, and other heavily regulated industries to avoid any distortions caused by industry-specific restrictions.
1.7 Significance of the Study
Business funding is an extremely significant business decision. Corporate finance managers must determine whether to use more debt or more equity; whichever measure is chosen has consequences. Everyone should remember that the main goal of any firm is to create a profit, and this study work will achieve the following through its findings:
The goal is to persuade corporate managers of the link between capital structure and business performance, allowing them to make informed decisions accordingly.
The statement can assist investors organise their capital structure to maximise profits.
Profitability is viewed as a primary influence of capital structure, along with bankruptcy costs, agency costs, taxes, information asymmetry, and other factors.
The topic of capital structure has been extensively researched, but the study is relevant in different time periods and contexts to determine whether the evidence about the capital structure issue and its numerous features is relevant to a specific set of enterprises in a certain period.
Given its significance, the current study seeks to comprehend and investigate capital structure and its impact on profitability, a crucial link that has hitherto received little attention in the context of major Nigerian enterprises.
This will benefit future scholars’ study efforts.
1.8 Definition of Terms
Capital structure is defined as the means by which an organisation provides funding for its general operations using several sources of money. It involves a combination of stock and debt.
Profitability is the measurement of a firm’s entire earning capability. Profitability is a firm’s major long-term goal for the development of its organisation throughout time.
Long-term assets are the value of a company’s property, tools, and other financial resources. These are shown on the left side of the balance sheet. Assets that are not intended to be converted into cash or used within one year of the balance sheet date.
Short term assets are assets kept by a corporation for less than a year. It contains accounts receivable, cash at bank, cash on hand, and so on. Current assets reflect an organization’s liquidity. These assets are used within a year or during the operational cycle without disrupting an organization’s routine processes.
Long-term liabilities are those that a corporation expects to pay out over a period of more than one year.
Short-term obligations are those that a firm is expected to pay in the short term, within one year or less, utilising assets that are conspicuous on its current balance sheet. Short term liability refers to obligations that can be settled with short-term assets.
Return on equity: The amount of money returned to shareholders from their equity, which calculates the prosperity of the owner’s assets. Return on equity measures an organization’s profitability by indicating how much profit a company generates from the money shareholders have invested.
Financial leverage is the use of fixed costs as a source of funding, such as debt and preference capital, in addition to the owner’s equity in the capital structure.
DEBT: Debt is a loan acquired from an outside source to fund a firm. It is repayable and receives a return in the form of interest charged on the outstanding loan balance.
EQUITY: A permanent investment in a corporation. Equity investing allows a person to become a part owner of the company. This is also a means of long-term funding. It contains share capital, premiums, and reserves.
Listed Quoted Companies: A firm whose shares can be bought 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.
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