THE IMPACT OF CAPITAL STRUCTURE ON FINANCIAL PERFORMANCE IN MANUFACTURING FIRMS IN NIGERIA

CHAPTER ONE

INTRODUCTION

BACKGROUND TO THE STUDY

Investors, governments and other external consumers of financial information also need to assess the efficiency of an entity. Performance assessment is carried out in order to assess the success of the business, to recognize any flaws in the business, to compare current and past performance and to compare current performance with industry norm. A organization can be regarded as operating successfully and efficiently if it can meet the desires of all its stakeholders. For example, managers are interested in their wellbeing and benefit maximization, current and future shareholders see success as the ability of the company to distribute dividends to their investment, corporate partners seek the solvency and stability of the company, while the state wants the company to be productive in paying its tax and helping to generate new jobs. The willingness of businesses to fulfill the needs of their stakeholders is closely connected to the capital structure (San and Heng 2011). The capital structure, along with other resources, plays a vital role in the firm’s financial decision-making process and the term is used to describe the proportionate relationship between debt and equity. Equity consists of the paid-up equity premium, share capital, reserve and surplus (retained earnings) (Pandey, 2010). Firms funding decisions include a broad variety of policy concerns concerning the capital structure, corporate governance and growth of businesses (Green, et al., 2002). Awareness of capital structures has largely been drawn from data from emerging economies with several structural parallels (Booth et al., 2011). The financial success of the company is determined by how well the firm is at the end of the time than it was at the beginning. Although there are many ways to calculate financial efficiency, the use of financial ratios has become widely accepted. Financial ratios reflect whether or not the company is meeting its objectives. The ratios can be used to compare the ratios of the company to other firms or to find performance patterns over time. To a large degree, firm financial success depends on its funding decisions. Its basic resource is the stream of cash flows produced by its properties. If the company is funded solely by common shares, all cash flows belong to the shareholders. When it offers both debt and equity securities, it undertakes to divide the cash flows into two sources, a reasonably stable stream that goes to the debt-holders and a more volatile one that goes to the shareholders. The substance of the financing decisions cannot be overemphasized as many of the factors that lead to a business failure can be resolved by a combination of financing decisions that drive growth and the achievement of firm objectives (Salazar, Soto and Mosqueda, 2012). The financial factor is the key cause of financial distress in a variety of situations (Memba and Nyanumba, 2013). Financing decisions result in a given capital structure, and decisions on sub-optimal financing can lead to corporate failure. This is a big question for management and investors alike are whether there is an ideal capital structure. The purpose of all financing decisions is to optimize wealth and the immediate way to assess the quality of any financing decisions is to analyze the impact of such decisions on the output of the company. The capital structure is the most critical discipline of the company’s operations (Pratheepkanth, 2011). The choice between debt and equity funding is built to find the best possible combination. Several studies indicate that an organization with a high debt appears to have an ideal capital structure and thus generates good financial results (Lindbergh, 2015; Pratheepkanth, 2011; Iavorskyi, 2013; Nirajini and Priya, 2013; Mujahid and Akhtar, 2014; Javed, Younas and Imran, 2014). However, Modigliani and Miller (1958, 2011), Soumadi and Hayajneh (2012), Simonovska, Gjosevski and Campos (2012), Siro (2013) and Mwangi, Makau and Kosimbei (2014) argue that they have no impact on the valuation of the company. These claims inspired scholars to further investigate the relationship between the capital structure and the financial performance of the company. The decision on funding or capital structure is a significant managerial decision as it affects the return and risk of the shareholder. The equity market is also influenced by the decision on the capital structure. The firm must prepare its capital structure right from the outset. In addition, a decision on the capital structure may be made in the future if additional funds are to be collected. The call for funds to be collected creates a new capital structure that requires a critical study. The capital structure is a combination of long-term debt, unique short-term debt, common equity and preferred equity. The capital structure measures how the company manages its overall activities and growth by using the various sources of funds available to it. Debt falls in the form of bonds or long-term notes payable, whereas equity is defined as ordinary stock, preferred shares, reserves or retained earnings. Short-term debt, such as labor capital needs, is often considered to be part of the capital structure. The proportion of the firm’s short-and long-term debt is regarded when assessing the capital structure. When people refer to the capital structure, they are most likely referring to the debt-to-equity ratio of the firm, which gives insight into how risky the firm is. Typically a company that is more heavily funded by debt faces a higher risk, since this firm is relatively highly leveraged. In Nigeria, very few studies have been carried out in this particular field with recent changes. This analysis is therefore carried out to determine the degree to which the capital structure of the listed manufacturing companies has an impact on their financial performance.

1. STATEMENT OF THE PROBLEM

There has been an ongoing discussion on the topic of corporate capital structure and financial efficiency. This debate is further narrowed to the identification of which of the variables discussed are most influential in predicting and deciding the capital structure of manufacturing firms. It is difficult to decide the option of the optimal capital structure of a company. A business must issue different securities in a multitude of combinations in order to find unique combinations that will optimize its total value, which implies an optimum capital structure. Optimal capital structure also ensures that with the lowest weighted-average cost of capital, the value of a business is maximized. According to Rahul (2013), poor capital structure decisions could lead to a potential reduction in the value of strategic assets. The capacity of a corporation to control its financial policies is therefore critical if the business is to make a profit from its specialized resources. The nature and scope of the relationship between the capital structure and the financial performance of firms has drawn the attention of many researchers. The option of capital structure is basically a marketing problem. In the case of Nigeria, the decision on capital structure is critical, as the decision becomes much more complicated, at a time when the economic climate in which the business operates poses a high degree of uncertainty (like the case of Nigeria). The firm may issue dozens of separate securities in innumerable combinations, but seeks to find a specific combination that maximizes its overall market value [Brealey et al, 2011]. The capital structure to be implemented by a corporation or entity is a vital decision for the management to take, the decisions are both critical and crucial because of the need to optimize returns to the different organizational groups and the effect of such decisions on the capacity of the organization to cope with its competitive climate. It is up to the company to determine whether to fund its investment by debt and/or equity. This crucial financial decision would have an effect on the debt-equity ratio (debt-equity mix) of the company. The consequences of this debt-equity combination are apparent in but not limited to the earnings of the shareholders, the cost of capital and the market value of the company impacted by the risk involved. Owing to these identified gaps, a study that will cover the various forms of financing mix in order to address the following questions that remain unanswered is desirable: to what extent do total debt to total assets ratio, total debt to total equity ratio, and the ratios of short-term and long term debt to total assets affect the performance of manufacturing firms in Nigeria? This thesis aims to provide answers to this fundamental issue. The key issue of this research is to study how the capital structure negatively or positively affects the financial output of manufacturing firms in Nigeria..

1. RESEARCH QUESTIONS

1. To what extent does total debt to total asset ratio affect financial performance of manufacturing firms in Nigeria?
2. What is the effect of total debt to total equity ratio on financial performance of manufacturing firms in Nigeria?
3. What is the impact of short-term debt to total assets ratio on financial performance of manufacturing firms in Nigeria?
4. How does long-term debt to total assets ratio influence financial performance of listed manufacturing firms in Nigeria?
   1. RESEARCH OBJECTIVES

The main aim of this study is to analyze the capital structure and financial results of manufacturing firms in Nigeria. Other general objectives of the analysis are as follows:

1. Examine the degree to which the total debt to the total asset ratio affects the financial output of manufacturing firms in Nigeria

2. Examine the effect of the total debt to the total equity ratio on the financial performance of manufacturing firms in Nigeria

3. Examine the effect of short-term debt on the total asset ratio on the financial output of manufacturing firms in Nigeria

4. Examine the effect of long-term debt on the total asset ratio on the financial output of listed manufacturing firms in Nigeria.

1.4 RESEARCH HYPOTHESES

Hypothesis 1

H0: Short term debt to total assets ratio does not have significant impact on the financial performance of manufacturing firms in the Nigeria.

H1: Short term debt to total assets ratio do have significant impact on the financial performance of manufacturing firms in the Nigeria

Hypothesis 2

H0: Long term debt to total assets ratio does not have significant impact on financial performance of manufacturing firms in the Nigeria.

H1: Long term debt to total assets ratio do have significant impact on financial performance of manufacturing firms in the Nigeria

Hypothesis 3

H0: Total debt does not have significant impact on financial performance of manufacturing firms in the Nigeria.

H1: Total debts do have significant impact on financial performance of manufacturing firms in the Nigeria

1.6 SIGNIFICANCE OF THE STUDY

The findings of the study will add to the current body of information. Since, while there are a lot of studies on capital structure and financial results around the globe, there is a lack of evidence using data from manufacturing firms in Nigeria. The outcome of the study would therefore serve as a reference material for future researchers and provide a basis for further research in this field. It is hoped that the findings of this study would help both internal and external parties (i.e. managers to optimize return on investors, owners to make informed decisions, creditors to assess the creditworthiness of the company, government to enforce favorable financing policies, etc to improve the contribution of the manufacturing sector to GDP and also to improve the employment rate once it has been developed. The Government and its agencies will also benefit from this report, as the study will highlight the need, if possible, for the Government to formulate more favorable financial and economic guidelines as needed by the sector, and this will sustain the operations of Nigerian manufacturing firms, in particular the potential firms still to be listed on the stock market and as a result. The results of this study will also benefit managers, shareholders and creditors of manufacturing firms in Nigeria. Managers must be put on a stable basis in order to appreciate the effects of the different funding mix on the operations of their companies. Shareholders will be able to make an informed decision on their equity interest in relation to the debt funding options open to their companies, while creditors would be able to recognise firms that are financially strong enough to resolve their claims as if they were due.

1.7    SCOPE OF THE STUDY 

The study is based on capital structure and financial performance in manufacturing firms in Nigeria.

1.8 DEFINITION OF TERMS

Management: – This is defined as the process of directing, co-ordination and influencing the operations of an organization so as to obtain desired result and enhance a total performance.

Money:- This can be defined as anything which passes freely from hand to hand and is generally acceptable in settlement of debt.

Hedging: According to (Ebhalaghe, 2010) defined hedging as a system employed to smoothen out unpredictable fluctuations in financial variables so as to aid planning and avoid embarrassment induced by cash shortfalls.

Capital Structure: Capital structure is a combination of debt and equity that corporate firms used to finance their business operations and growth activities.

Profitability: Profitability is seen as proxy of financial performance, which is one of the main objectives of company’s management.