The relationship between capital structure and profitability of firms listed at the Nairobi Securities Exchange

Abstract

The decision of capital structure is important for any firm. It is challenging for a company to identify the correct variations of debt and equity. To create a conducive environment for business in the nation, the government has invested heavily and as a result, various firms have performed well.Conversely, many firms are experiencing downward performance while others have even been delisted from the NSE within the last seven years. Therefore, the main objective of this study was to examine the relationship between capital structure and profitability of 37 selected firms listed at the NSE while controlling for moderating variables that included sales growth, firm size, and asset tangibility. Financial services firmslisted between 2009 and 2013 and suspended counters were excluded from the study. The researcher utilized the pecking order theory of capital structure that states that firms have a specific hierarchy they follow to finance their activities. A longitudinal research design, using secondarydataderived from firms’ annual audited reports and information from NSE handbooks were used in this study. Descriptive and inferential statistics were used to examine the relationship between capital structure and the profitability of firms listed at the NSE. Data was cleaned and run through the Statistical Package for Social Sciences (SPSS) version 24by analyzing one hundred and eight observations out of a possible 185 by eliminating missing data, outliers that would have made the model inconsistent for all the listed non-financial firms for the study period. This was done to regularize and to ensure that the analysis would reveal results that were more accurate. Descriptive statistics revealed thatfirms performed relatively well as compared to the industry average as measured by ROCEconsidering the economic and political climate in Kenya at the time was not favorable. The results also suggested that firms in Kenya were more reliant on short-term debt than long-term debt. For equity structure, the results revealed that firms preferred internal equity to external equity and that this was consistent through the period. The relative slow growth was brought about by the stagnant economic condition at the time. The results indicated that firms also retained most of their assets in fixed form. Pearson correlation results revealed that firm’s profitability measured by ROCE was significant and positively correlated with internal equity. Long-term debt was inversely correlated with ROCE and significant. Short-term debt was found to have a negative statistical significance relationship with profitability whereas external equity was found not to have a statistically significant relationship with profitability. Asset tangibility on the other hand was not statistically significant related to ROCE. Results also revealed that sales growth had a significant relationship with profitability while firm size was statistically insignificant in determining profitability of firms.The multiple regression model summary revealed that the model was well suited to explain the relationship between capital structure and profitability of firms listed at the NSE. It was concluded that non-financial firms listed in NSE are more reliant on equity financing than debt financing. The study recommended that Kenyan firms should use more internal equity to ascertain profitability as it does not involve costs of acquisition compared with external equity and debt finance.