THE EFFECT OF CAPITAL STRUCTURE ON THE FINANCIAL PERFORMANCE OF SMALL AND MEDIUM ENTERPRISES IN THIKA SUB-COUNTY EDWIN MARANGA BIRUNDU D63/61327/2013

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1 THE EFFECT OF CAPITAL STRUCTURE ON THE FINANCIAL PERFORMANCE OF SMALL AND MEDIUM ENTERPRISES IN THIKA SUB-COUNTY BY EDWIN MARANGA BIRUNDU D63/61327/2013 A RESEARCH PROJECT SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE AWARD OF THE DEGREE OF MASTER OF SCIENCE IN FINANCE, SCHOOL OF BUSINESS OF THE UNIVERSITY OF NAIROBI NOVEMBER 2014

2 DECLARATION This research project is my original work and has not been presented in any other examination body. No part of this research project should be produced without my consent or that of the University of Nairobi. Signature.. Date: Name: Edwin Maranga Birundu. REG: D63/61327/2013 DECLARATION This research project has been submitted with the approval of the University of Nairobi SUPERVISOR Signature Date. Name: Mr. Mwangi W. Mirie Lecturer, Department of Finance and Accounting School of Business, University of Nairobi. ii

3 ACKNOWLEDGMENT I would like to first and foremost thank God for helping me through and giving me the strength to achieve this. My special thanks to my supervisor, Mr. Mwangi W. Mirie for his continued advice and guidance over the research period. I also thank the lecturers, administration staff and support staff of the University of Nairobi for their support through the entire program period. To my parent, friends and classmates for supporting me throughout the course especially where matters of group work and revision were concerned. Last I wish to thank the entire fraternity of PKF Kenya for their supports God bless them. May the Almighty God bless you all greatly! iii

4 DEDICATION This paper is dedicated to my Mother Mrs Elizabeth Kemunto Nyantika for her support, to my sibling Ryan Momanyi and my sister Leoninda Birundu I encourage them work hard in school, and to my wife Rosebell wahu for her support and encouragement to see me through. iv

5 TABLE OF CONTENTS DECLARATION... ii ACKNOWLEDGMENT... iii DEDICATION... iv LIST OF TABLES... vii LIST OF FIGURES... viii LIST OF ABBREVIATIONS... ix CHAPTER ONE:...1 INTRODUCTION Background of the Study Capital Structure Firms Financial Performance Capital Structure and Financial Performance Small and Medium Size Enterprises in Thika Sub-County Research Problem Research Objective Value of the Study...12 CHAPTER TWO:...13 LITERATURE REVIEW Introduction Theories of Capital Structure Capital structure Irrelevance Theory Static Trade-off Theory Agency Costs Based Theory Pecking Order Theory Determinants of Financial Performance of SMEs Asset Turnover Asset tangibility Profitability Firm Size Firm Growth Liquidity Non-Debt Tax Shields Empirical Evidence Summary of the Literature Review...26 CHAPTER THREE...29 RESEARCH METHODOLOGY Introduction Research Design The Population Sample Design Data Collection Data Analysis Research Model Measurement of Variables Independent Variables Dependent Variables...33 CHAPTER FOUR...34 DATA ANALYSIS, RESULTS AND DISCUSSION...34 v

6 4.1 Introduction Response Rate Data Validity Descriptive Statistics Debt Ratio Asset turnover Asset tangibility Financial performance of SMEs Correlation Analysis Regression Analysis and Hypothesis testing Discussion of Research Findings...40 CHAPTER FIVE...43 SUMMARY, CONCLUSION AND RECOMMENDATIONS Introduction Summary of the Findings Conclusions Recommendations Limitations of the Study Suggestions for Further Research...47 REFERENCES...49 APPENDICES...57 Appendix I: Debt Ratio...57 Appendix II: Asset Turnover...59 Appendix III: Asset Tangibility...61 Appendix III: Return on Asset...63 vi

7 LIST OF TABLES Table 4.1: Correlation Matrix..28 Table 4.2: Model Summary..28 Table 4.3: Analysis of Variance (ANOVA). 29 Table 4.4: Coefficients of Determination...29 vii

8 LIST OF FIGURES Figure 4.1: Debt Ratio of SMEs in Thika 26 Figure 4.2: Asset Turnover of SMEs in Thika. 27 Figure 4.3: Asset tangibility of SMEs in Thika...27 Figure 4.4: Return on assets of SMEs in Thika...28 viii

9 LIST OF ABBREVIATIONS ANOVA - Analysis of Variance GDP - Gross Domestic Product GPM - Gross Profit Margin KBS - Kenya Bureau of Statistics MM - Modigliani and Miller NDTS - Non Debt Tax Shield NPS - Net Profit Margin NSE - Nairobi Security Exchange OLS - Ordinal Least Square ROA - Return on Asset ROCE - Return on Capital Employed ROE - Return on Equity SDTA - Short-Term Debt to Total Assets Ratio SMEs - Small and Medium Enterprises ix

10 ABSTRACT The objective of this research is to determine the effect of capital structure on the financial performance of small and medium enterprises in Thika sub-county. In most cases, it is expected the capital structure of a firm should have some effects on the performance of SMEs. The study was conducted on 40 SMEs in Thiks sub-county which were in operation for the five years of study from 2009 to The various ratios and analysis of these SMEs were computed from the various data collected and extracted from their financial statement for the period. The data was then analyzed using linear regression models using SPSS20 to establish if there were any significant effect of capital structure and the financial performance of these SMEs. The finding of the analysis concluded that there were no significant effect between the capital structure and the financial performance of SMEs in Thika sub-county based on the variable factored during this study. There was very minimal effect which is negligible and therefore it was concluded that there is minimal effect between capital structure and financial performance of SMEs in Thika sub-county. Therefore we recommend that additional research should be conducted in other areas and factoring other variable which were not factored and identify which are the major factors that affect the performance of their industry. This will enable them to control these factors to ensure maximum profitability is attained and sustained for the growth of the industry. x

11 CHAPTER ONE: INTRODUCTION 1.1. Background of the Study The contribution of Small and Medium Enterprises (SMEs) to an economy has been viewed from the point that all consumers would prefer products that are more personalized (Roshanak, 2013), this has create inherent pressures towards making markets smaller and smaller same as to say, more and more particularized to the demands of individual consumers. The managerial costs of satisfying the demands of small markets are high as compared to big and generalized markets. SMEs serve an economy by satisfying the demands of small markets for which there are no or lower scale economies of production or distribution. SMEs also serve an economy by satisfying demands where the managerial costs of large business are greater than the market transaction costs of dealing by contract rather than by control within a firm (Mazur, 2007). The way small business mobilize and structure the capital is a subject of interest. Capital refers to the resources that a business owns. These resources can have the input of the owner(s) and or non-owner(s) or debtor(s). The input of the owner(s) is called equity and the input of non-owner(s) for the purpose to repay with interest is called debt (Gunasekaran, 2010). The composition of capital with respect to debt and equity is referred to as capital structure. Both debt financing and equity financing have very different potential incentive problems. To understand how SMEs finance their operations, it is necessary to examine the determinants of their financing or capital structure decisions. SMEs financing decisions involve a wide range of policy issues. 1

12 The relationship between capital structure and financial performance is one that received considerable attention in the finance literature. How important is the concentration of control for the company performance or the type of investors exerting that control are questions that authors have tried to answer for long time The study the impacts of capital structure or financial performance, will help us to know the potential problems in finance performance and capital structure (Matibe, 2005). Capital structure has been a major issue in financial economics ever since Modigliani and Miller showed in 1958 that given frictionless markets, homogeneous expectations capital structure decision of the firm is irrelevant. SMEs may face difficulties in raising finance (debt component) due to information asymmetry and other inefficiencies in loan markets. Inevitably, this has a serious impact on their capital structures. Taking cognizance of exceptions, asymmetric information can also explain the dominance of debt financing over equity issues in practice, as the bulk of external financing is expected to come from commercial banks and micro-finance institutions (Bebczuk, 2003). Strong financial systems, which provide loans/credits to investors/businesses, can directly and indirectly create employment and alleviate poverty in an economy (Honohan and Beck, 2007). Credit system also facilitates the process of job creation in which some will become self-employed entrepreneurs while others involved in other business related activities (Thomas, 1992). Economists and financial researchers have sought to establish the factors that determine the capital structure. It has been researched in various locations but with varied results as will been shown in the next charter, Literature Review. The factors that appear to determine capital structure are many but this research will still within the parameters of three factors including profitability, growth, size, asset 2

13 structure and age (Wald, 1999). Profitability refers to the net income with respect to capital-net income to capital ratio. This means that the higher the net income to capital ratio, higher the profitability and vise-versa. Growth shall be defined as a consistent increase in the number of employees. Size refers the number of employees (Mazur, 2007). Asset structure refers to the value of fixed asset with respect to capital. Finally, age is the number of years of existence with respect to the years being studied (Roshanak, 2013). Financing and investment are two major decision areas in a firm. In the financing decision the manager is concerned with determining the best financing mix or capital structure for his firm. Capital structure decision is the mix of debt and equity that a company uses to finance its business (Damodaran, 2001). (Berger & di Patti, 2006) concluded that more efficient firms were more likely to earn a higher return from a given capital structure, and that higher returns can act as a cushion against portfolio risk so that more efficient firms are in a better position to substitute equity for debt in their capital structure. This is an incidental of the trade-off theory of capital structure where differences in efficiency enable firms to alter their optimal capital structure either upward or downwards Capital Structure A firm s capital structure refers to the mix of its financial liabilities. As financial capital is an uncertain but critical resource for all firms, suppliers of finance are able to exert control over firms (Harris and Raviv, 1991). Debt and equity are the two major classes of capital, with debt holders and equity holders representing the two types of investors in the firm. Each of these is associated with different levels of risk, benefits, and control. It is the way the corporation finances its assets through some combination of 3

14 equity, debt, or hybrid securities. A firm s capital structure is then a composition or structures of its liabilities. Over the past years much of the capital structure research has advanced theoretical models to explain the capital structure pattern and also to provide empirical evidence concerning whether the theoretical models have explanatory power when applied to the real business world. The focus of both academic research and practical financial analysis has been on those large corporations with publicly traded debt and equity securities that dominate economic life throughout the developed world. Capital structure research has become increasingly internationalized in recent years, which provides researchers the opportunity to make cross-sectional comparisons between countries and between various industries around the world. (Wald, 1999) examined characteristics of firms that were not similarly correlated with leverage across countries. He demonstrated that institutional differences could contribute to differences in capital structure. His results indicate that institutions may significantly influence firms capital structure decision and that agency and monitoring problems, while existing in every country, may create different outcomes. (Booth, 2001) provided the first empirical study to test the explanatory power of capital structure models in developing countries. The study used data from 10 developing countries to assess whether capital structure theory was portable across countries with different institutional structures. It investigated whether the stylized facts, which were observed from the studies of developed countries, could apply only to these markets or whether they had more general applicability. The results were somewhat skeptical of this premise. They provided evidence that firms capital choice decisions in developing countries were affected by the same 4

15 variables as they were in developed countries. This study will use debt ratio as a measure of the independent (explanatory) variable. This will serves as the proxy for capital structure. However, a number of factors may impact on firm performance, hence, the need for controlled variables to be included in the model Firms Financial Performance A firm s financial performance, in the view of the shareholder, is measured by how better off the shareholder is at the end of a period, than he was at the beginning and this can be determined using ratios derived from financial statements mainly the balance sheet and income statement, or using data on stock market prices (Berger and Patti, 2002). These ratios give an indication of whether the firm is achieving the owners objectives of making them wealthier, and can be used to compare a firm s ratios with other firms or to find trends of performance over time. The main objective of shareholders in investing in a business is to increase their wealth. Thus the measurement of performance of the business must give an indication of how wealthier the shareholder, has become as a result of the investment over a specific time. Performance having different meanings depending on the user perspective of financial information, a company can be categorized as global performance if it can satisfy the interests of all stakeholders (Roshanak, 2013). The financial performance of SMEs can be measured using a number of indicators firms size, profitability and growth rate. The performance is a general term applied to a part or to all the conducts of activities of an organization over a period of time often with reference to past or projected cost efficiency, management responsibility or accountability. Thus, not just the presentation, but the quality of results achieved refers to the performance. Performance is used to indicate firm s success, conditions, and compliance. 5

16 The recommended measures for financial analysis that determine a firm s financial performance are grouped into five broad categories: liquidity, solvency, profitability, repayment capacity and financial efficiency (Mazur, 2007). It is important to remember that past and present financial information are not the only factors affecting a firm s financial performance. Liquidity measures the ability of the firm/business to meet financial obligations as they come due, without disrupting the owner equity, using the market value of assets and including deferred taxes in the liabilities. Three widely used financial ratios to measure solvency are the debt-to-asset ratio, the equity-to-asset ratio (sometimes referred to as percent ownership) and the debt-to-equity ratio (sometimes referred to as the leverage ratio). The debt-to asset ratio expresses total farm liabilities as a proportion of total farm assets. The higher the ratio, the lower the performance of the firm and the greater the risk involved (Gunasekaran, 2010). Profitability measures the extent to which a business generates a profit from the factors of production, labor, management and capital. Profitability analysis focuses on the relationship between revenues and expenses and on the level of profits relative to the size of investment in the business. Repayment capacity method measures the ability to repay debt from both firm and non-firm income. It evaluates the capacity of the business to service additional debt or to invest in additional capital after meeting all other cash commitments (Roshanak, 2013). The analysis of financial statements is an important aid to financial performance analysis. Financial performance analysis includes analysis and interpretation of financial statements in such a way that it undertakes full diagnosis of the profitability and financial soundness of the business. (Metcalf and Titard, 1976) claims that the financial performance analysis identifies the financial strengths and weaknesses of the 6

17 firm by properly establishing relationships between the items of the balance sheet and profit and loss account. The study will employs return on Assets (ROA) as the two dependent variables, and measures of firm financial performance (Metcalf and Titard, 1976). Although there is no unique measurement of firm performance in the literature, ROA were chosen because they are important accounting based and widely accepted measures of financial performance. ROA can also be viewed as a measure of management s efficiency in utilizing all the assets under its control, regardless of source of financing Capital Structure and Financial Performance (Hutchinson, 1995) in his scholarly works argued that, financial leverage had a positive effect on the firm s return on equity provided that earnings power of the firm s assets exceeds the average interest cost of debt to the firm. (Taub, 1975) also found significantly positive relationship between debt ratio and measures of profitability. (Nerlove, 1968), (Baker, 1973), and (Petersen and Rajan, 1994) also identified positive association between debt and profitability but for industries. In their study of leveraged buyouts, (Roden and Lewellen, 1995) established a significantly positive relation between profitability and total debt as a percentage of the total buyout-financing package. However, some studies have shown that debt has a negative effect on firm profitability. (Fama and French, 1998), for instance argue that the use of excessive debt creates agency problems among shareholders and creditors and that could result in negative relationship between leverage and profitability. (Majumdar and Chhibber, 1999) found in their Indian study that leverage has a negative effect on performance. (Gleason, 2000) support a negative impact of leverage on the profitability of the firm. 7

18 In a polish study, (Hammes, 1998) also found a negative relationship between debt and firm s profitability. In another study, (Hammes, 2003) examined the relation between capital structure and performance by comparing Polish and Hungarian firms to a large sample of firms in industrialized countries. He used panel data analysis to investigate the relation between total debt and performance as well as between different sources of debt namely, bank loans, and trade credits and firms performance measured by profitability. His results show a significant and negative effect for most countries. He found that the type of debt, bank loans or trade credit is not of major importance, what matters is debt in general. (Mesquita and Lara, 2003), in their study found that the relationship between rates of return and debt indicates a negative relationship for long-term financing. They however, found a positive relationship for short-term financing and equity. (Abor, 2007) in his scholarly works on debt policy and performance of Medium Sized Enterprises found the effect of short-term debt to be significantly and negatively associated with gross profit margin for both Ghana and South African firms. This indicated that increasing the amount of short-term debt would result in a decrease in the profitability of the firms Small and Medium Size Enterprises in Thika Sub-County Thika Sub-County is a home to large industries in Kenya including tanneries textiles, footwear, food processing, motor vehicle assembly and cigarette manufacturing and over a hundred light industries. Majority of the enterprises in Thika Sub-County are SMEs, some are faced with challenges of accessing fund to finance their business and therefore the adequate financial knowledge remain a constraints within the region. 8

19 Small and Medium Enterprises (SMEs) contribute greatly to the economies of all countries, regardless of their level of development, it is the major source of employment, it generation domestic and export earnings and are a key instrument in poverty reduction (Mephokee, 2004). In Kenya, the SMEs sector employs 74% of the labor force and contributes over 18% of the country s gross domestic product (GDP), (Ngugi, 2012). Generally, SMEs are defined by the number of workers employed, value of assets and sales turnover (Garikai, 2011). The term SMEs covers a wide range of perceptions and measures, varying from country to country and between the sources reporting SME statistics. Some of the commonly used criterions are the number of employees, total net assets, sales and investment level. However, the most common definitional basis used is employment, many researchers define Small and Medium Enterprises in terms of the numbers of people employed. (Storey, 1994), for example, defines micro-enterprises as those with 0 to 9 employees, those with 10 to 99 workforces as small business, and medium sized enterprises as having 100 to 499 employees. (Gunasekaran & Kobu, 2000), however, states that Small and Medium Enterprises have to be defined within the context of the economies in which they operate. (Waweru, 2007) posits that SMEs in Kenya are characterized by the ease of entry and exit the small scale nature of activities self-employment with a high proportion of family workers and apprentices the little amount of capital and equipment. Further, they have labour intensive technology, low level of skills and low level of organization with little access to organized markets. Other observations by (Waweru, 2007) are their unregulated and competitive markets, their limited access to formal credit, the existent low levels of education and training and the limited access to services and amenities. 9

20 1.2. Research Problem The continued poor performance coupled with closure of medium sized enterprises has raised more questions than answers to researchers and practitioners. It is also pointed out that the increase from 6.7% to 10.4% in June 2013 in commercial institutions non-performing assets was attributable by small and medium firms failure to service their loans due to insufficient financial resources (RSM, 2013 banking survey), the capital structure employed by such firms could be a reason influencing their financial performance trends, this issue has not been given much attention as expected. According to (Agn, 1992), small businesses are not engaged in the problems, as well as opportunities, of large firms. However, small firms face different complexities, such as the presence of tax, shorter expected life than large firms, intergenerational transfer problems, and prevalence of implicit contracts. Moreover, (Pettit and Singer, 1985) argued that standard problems like asymmetric information and agency cost is more severe in small firms than large firms. Studies on the failure of the SMEs reveal that financial leverage is a main cause of decline (Otieno, 1987). SMEs borrowing decisions are different form large companies, due to the borrowing constraints they face. (Metha, 1981) argued that "resource poverty" is one of the most frequently cited reasons for business failure. Bigger business can seize the opportunity and win the market. External forces such as government regulations and tax laws are felt more acutely by small ventures than by large ones. Frequently, small ventures cannot afford the professional expertise of accountants like large firms can. (Kuria, 2010) found that profitability and tangibility are significantly negatively related to leverage as also liquidity growth and taxation but are insignificant. While 10

21 risk was seen to have a significant positive relationship but an insignificant one for dividend policy and non-debt tax shield. (Kiogora, 2000) indicates that there is a complex array of factors that influence SMEs owners/managers' financing decisions. These processes are influenced by firm owners' attitudes toward the utility of debt as a form of funding as moderated by external environmental conditions (e.g., financial and market considerations). The form of business also has an impact on the owners' attitudes towards the utility of debt as a form of funding. For example, sole proprietorships and partnerships are sensitive to the risk of unlimited liability. A number of other factors have been shown to influence financing decisions including profitability, growth prospect, assets structure, size and age. (Kinyua, 2005) established that profitability, company size, asset structure, management attitude towards risk and lenders attitude towards the company are key determinants of capital structure for small and medium enterprises in Kenya. Despite SMEs using different sources of financing some of them are still stagnated and others are failing. This could be attributed to lack of knowledge on the best sources of financing with majority of SME owners having no ideas on how debts and internal sources of finance influence their financial performance. There is little that has been done to provide viable solutions on which side of financing will benefit financial performance of SMEs especially in Kenya. Thus, this study sought to fill this research gap by answering, the effect of capital structure on the financial performance of SMEs in Kenya particularly in Thika Sub-County? 1.3. Research Objective The objective of this study was to determine the effect of capital structure on the financial performance of SMEs in Thika Sub-County. 11

22 1.4. Value of the Study The study will assist policymakers in formulating effective strategies and policies to curb under performance of SME. Scholars and researcher s knowledge and information realized through this research undertaking will benefit other future scholars who wish to study the same area as it provides an insight of what has not been examined. SME capital structure is rapidly growing as a field of practice. Many business leaders believe that there is need to make effective financial decisions. The findings will inform appropriate policy making and implementation that could spur the growth of SMEs into medium-sized companies. In addition, the study provided information to the SME' owners on the problems that generally face them and on how best they can be able to solve the challenges. Prospective entrepreneurs might find the conclusions on the challenges that face the SME sector useful on how best they can surmount them upon entry into business. The research helped to elucidate on how well capital structure could explain the growth of SMEs within Thika Sub- County. 12

23 CHAPTER TWO: LITERATURE REVIEW 2.1 Introduction This chapter will present a review of the theoretical and empirical literature on the effect of capital structure on the financial performance of SMEs in Thika Sub- County. The section starts with the capital structure theories, empirical reviews and then to the determinants of financial performance. The conceptual framework, incorporate scholarly works and theories, the rationale of the study is to ascertain the role capital structure played in determining financial performance Theories of Capital Structure Finance theory has made major advances in understanding effect capital structure on financial performance of SMEs, the following are some of modern financial theories on capital structure Capital structure Irrelevance Theory The initial theory of capital structure was first developed in 1958 by economists Franco Modigliani and Merton Miller known as MM Theory. The Irrelevance Theory showed that a firm's value is independent of its ratio of debt to equity financing with the assumptions that, neutral taxes, no capital market frictions (i.e. no transaction costs, asset trade restrictions or bankruptcy costs), symmetric access to credit markets (i.e. firms and investors can borrow or lend at the same rate) and firm financial policy reveals no information. Cost of capital does not affect capital structure, particularly debt then not effect on firm value In other words, the value of levered firm equals the value of unlevered firm. 13

24 Subsequently in their 1963 paper, Modigliani and Miller relaxed the assumptions by introducing taxes into their model in which case the method of financing becomes relevant. In the relaxation of the assumptions of the Irrelevance Theory, (Modigliani and Miller, 1963), suggests that capital structure can alter the value of a firm in the world of corporate tax and a firm can maximize it value by the use of debt which provides an interest tax shield. A firm has more value if it uses debt financing because debt reduces the corporate tax. The savings due to the use of debt adds to the value of the firm. The firm that uses more debt saves more in the form of corporate tax shield. This suggests that debt is a preferable source of financing for less taxation is laid on debt. (Modigliani and Miller, 1963). Therefore the theory acknowledge that if capital structure is optimal at 100% debt financing it will minimize the weighted average cost of capital and maximizes firm performance. However, according to the theory there is a positive relationship between firm s leverage and its performance but the theory has not taken into consideration other factors that affect leverage and the different sizes of the firm Static Trade-off Theory Static Trade-off suggests that a firm sets a target debt-equity ratio and gradually follows it. Debt has an advantage of tax shield (Modigliani and Miller, 1963). However, debt cannot be indefinitely used as the source of financing as there is a trade-off between tax shield advantage on one hand and bankruptcy cost and financial distress on the other hand (Jensen and Meckling, 1976). Debt financing has one major advantage over equity financing-the interest on debt is deducted before corporate tax is paid. But debt also increases financial risk. 14

25 This makes debt-financing not emphatically less costly than equity-financing. A firm that considers static trade-off, threats debt-equity decision as a give and take between the cost of financial distress and tax shield of debt respectively. Give and take as use here means cost and benefit. Capital structure reflects tax rates, assets type, business risk, profitability and bankruptcy costs (Myers, 1984). Generally, if the cost of debt is low and the corporate tax rate is high to the extent that the firm benefit significantly from debt financing, the form will use more debt since the marginal taxrate on debt is less than the corporate tax rate. This will lead the firm to a positive net tax advantage if it uses debt-financing. Here the firm s optimal capital structure will involve the trade-off between the tax advantage of debt and various leverage-related costs (Niu, 2008). Distinction in firms characteristics leads to variation in the target debt-equity ratio. The trade-off theory predicts that safe firms, firms with more physical/tangible assets and higher tax rate will have higher debt-equity ratio. Firms that are risky (firms with more nonphysical/intangible assets) ought to have more equity-financing (Niu, 2008). Static Trade-off theory suggests that a firm that is profitable is likely to have more debt as it would want to shield its income from taxes. This means that a firm that in its profitable period will use more debt-financing. Static Trade-off theory therefore suggests that there is a positive relationship between the firm s leverage and performance. However there is no clear consensus on the link between capital structure and firms financial performance Agency Costs Based Theory (Berle and means, 1932) put forward the agency theory which also contributes to the capital structure decision. The theory argues that conflicts arise from the possible divergence of interests between shareholders (principals) and managers (agents) of 15

26 firms. The primary duty of managers is to returns to shareholders thereby increasing the profit figures and cost cash flows (Elliot and Chiber, 2002). However, (Jensen and Meckling, 1976) and (Jensen and Ruback, 1983) argue that managers do not always run the firm to maximize returns to shareholders. As a result of this, managers may adopt non-profitable investments, even though the outcome is likely to be losses for shareholders. They tend to use the three cash flow available to fulfill their personal interest instead of investing in positive not present value projects that would benefit the shareholders. (Jensen, 1986) argues that the agency cost is likely to exacerbate in the presence of free cash flow in the firm. In an effort to mitigate this agency conflict, (Pinegar and Wilbruch, 1989) argue that capital structure can be used through increasing the debt level and without causing any radical increase in agency costs. This will force the managers to invest in profitable ventures that will be of benefit to the shareholders. If they decide to invest in non-profitable projects and they are unable to pay the interest due to debt holders, the debt holders can force the firm to liquidation and managers will lose their decision rights or possibly their employment. Agency theory contributes that leverage firms are better for shareholders as debt level can be used for monitoring the managers (Boodhoo, 2009). Thus, higher leverage is expected to lower agency costs, reduce inefficiency and thereby lead to improvement in a firm s performance. Empirical supports for the relationship between capital structure and firm performance from the agency perspective are many and in support of negative relationship. (Zeitun and Tian, 2007), using 167 Jordanion companies over fifteen year period ( ), found that a firm s capital structure has a significant negative impact on the firm s performance indicators, in both the 16

27 accounting and market measures. (Rao and Syed, 2007) also confirm negative relationship between financial leverage and performance. Their results further suggest that liquidity, age and capital intensity have significant influence on financial performance. Hence the disjunction at this level has posted a challenge that there is no consensus between capital structure and firm s financial performance Pecking Order Theory The pecking order theory was developed by (Myers, 1984) stated that firms prefer internal sources of finance they adapt their target dividend payout ratios to their investment opportunities although dividends and payout ratios are gradually adjusted to shifts in the extent of valuable investment opportunities. Pecking Order theory tries to capture the costs of asymmetric information. It states that companies prioritize their sources of financing (from internal financing to equity) according to the law of least effort, or of least resistance, preferring to raise equity as a financing means of last resort. Hence internal financing is used first when that is depleted, then debt is issued and when it is no longer sensible to issue any more debt, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required (equity would mean issuing shares which meant 'bringing external ownership' into the company). Thus, the form of debt a firm chooses can act as a signal of its need for external finance. The pecking order theory is popularized by (Myers, 1984) when he argues that equity is a less preferred means to raise capital because when managers (who are 17

28 assumed to know better about true condition of the firm than investors) issue new equity, investors believe that managers think that the firm is overvalued and managers are taking advantage of this over-valuation. As a result, investors will place a lower value to the new equity issuance. (Myers, 1984) and (Macan and Lucey, 2011) 2.3. Determinants of Financial Performance of SMEs A number of empirical studies have identified firm level characteristics that affect the capital structure of firms and these include Asset Turnover Asset turnover is defined as the ratio of sales to total assets. Assets play important role in leverage level of firms. A firm with large amount of fixed assets can borrow at relatively lower rate of interest by providing the security of these assets. Having the incentive of getting debt at lower interest rate, a firm with higher percentage of fixed asset is expected to borrow more as compared to a firm whose cost of borrowing is higher because of having less fixed assets. Tangible assets are less subject to informational asymmetries and usually they have a greater value than intangible assets in the event of bankruptcy. The trade-off theory predicts a positive relationship between measures of leverage and the proportion of tangible assets. Relative to this theory, (Bradley, Javrell and Kim, 1984) Asset tangibility Asset tangibility is defined as the ratio of net tangible asset to total assets. Assets play important role in leverage level of firms and its turnover. A firm with large amount of fixed assets can borrow at relatively lower rate of interest by providing the security of these assets also its associated that if the assets are used efficiently 18

29 they will increase its turnover. Having the incentive of getting debt at lower interest rate, a firm with higher percentage of fixed asset is expected to borrow more as compared to a firm whose cost of borrowing is higher because of having less fixed assets. Tangible assets are less subject to informational asymmetries and usually they have a greater value than intangible assets in the event of bankruptcy Profitability There are two opposite views relating relationship between profitability and leverage. (Myers, 1984) in his pecking order theory predicts that firms prefer raising capital from retained earnings, then from debt, then from issuing equity. The cost of capital dictates the rank of the pecking order under asymmetric information and market imperfections. If pecking order applies, then, higher profitability will correspond to a lower debt ratio holding other things equal. As a result, pecking order theory assumes negative relationship between leverage and profitability. Studies conducted by (Danbolt and Bevan, 2001) empirically proved negative relation between leverage and profitability. In the trade off theory, agency costs, taxes and bankruptcy costs push more profitable firms toward higher book leverage. First, expected bankruptcy costs decline when profitability increases. Secondly, the deductibility of corporate interest payments induces more profitable firms to finance with debt. In a trade-off theory framework, when firms are profitable, they prefer debt to benefit from the tax shield. In addition, if past profitability is a good proxy for future profitability, profitable firms can borrow more, as the likelihood of paying back the loans is greater. In the agency models of (Jensen and Meckling, 1976), higher leverage helps control agency problems by 19

30 forcing managers to pay out more of the firms excess cash. Accordingly, the trade-off theory predicts a positive relationship between profitability and leverage Firm Size There are two conflicting viewpoints about the relationship of size to leverage of a firm. According to trade off theory, larger firms are well diversified, having stable cash flows and their chances of bankruptcy are less as compared to small firms. Therefore, large firms prefer leverage and are having high level of leverage (Myers and Majilu, 1984). Due to the large size, high level of fixed assets, economies of scale, stable cash flow and creditworthiness larger firms have the bargaining power over lender and can borrow at relatively lower rate. Thus, large firms are expected to hold more debt in their capital structure than small firms. Following this, one may expect a positive relationship between size and leverage of a firm. Second, contrary to first view, (Rajan and Zingales, 1995) argue that there is less asymmetrical information about larger firms. This reduces the chances of undervaluation of the new equity issue and thus encourages the large firms to use equity financing. This means there is negative relationship between size and leverage of a firm Firm Growth Empirically, there is much controversy about the relationship between growth rate and level of leverage. According to pecking order theory hypothesis, a firm will use first internally generated funds which may not be sufficient for a growing firm so the next option is for the growing firms to use debt financing which implies that a growing firm will have a high leverage (Drobetic and Fix, 2003). Hence, pecking order theory assumes positive relationship between leverage and growth. 20

31 On the other hand, agency costs for growing firms are expected to be higher as these firms have more flexibility with regard to future investments. The reason is that bondholders fear that such firms may go for risky projects in future as they have more choice of selection between risky and safe investment opportunities. Because of that bondholders will impose higher costs at lending to growing firms. Growing firms, thus, facing higher cost of debt will use less debt and more equity. (Rajan and Zingales, 1995) find a negative relationship between growth and leverage. In this study, growth is taken to have a positive relationship with leverage Liquidity There are two opposite views relating the relationship between liquidity and leverage. According to trade off theory, the more liquid firm would use external financing due to their ability of paying back liabilities and to get benefit of tax shields, resulting in positive relationship between liquidity and leverage. Pecking order theory assumes that the more liquid firm could use first its internal funds and would decrease level of external financing, resulting in negative relationship between liquidity and leverage. Most studies have found the negative relationship (Mazur, 2007). In this study negative relationship between liquidity and leverage is expected. Not many studies have tested the effect of liquidity on the choice of capital structure. (Mazur, 2007) and (Ullah, 2011) measured liquidity as the ratio of current assets to current liabilities. In this study, Liquidity will also be measured as the ratio of current assets to current liabilities Non-Debt Tax Shields The effective tax rate has been used as a possible determinant of the capital structure choice. According to (Modigliani and Miller, 1963), if interest payments on debt are 21

32 tax deductible, firms with positive taxable income have an incentive to issue more debt. That is, the main incentive for borrowing is to take advantage of interest tax shields. Other items apart from interest expenses, which contribute to a decrease in tax payments, are labelled as non-debt tax shields (NDTS), for example the tax deduction for depreciation and investment tax credits. (Angelo and Masulis, 1980) argue that non-debt tax shields are substitutes for the tax benefits of debt financing and a firm with larger non-debt-tax shields, ceteris paribus, is expected to use less debt. Therefore, the relation between non-debt tax shields and leverage should be negative. (Angelo and Masulis, 1980) measured non-debt-tax shields as depreciation divided by total assets as in most studies. Depreciation divided by total assets is used in order to proxy for non-debt tax shield in this study Empirical Evidence This section discusses studies which have been conducted locally and internationally, which examined the impact of capital structure on financial performance. (Chode, 2003) studied impacts of capital structure of public enterprises in Kenya on its financial performance. His period of study was between 1994 and He used regression analysis and found out that enterprises depended on public funding and also found a positive relationship between debt and financial performance of the organisation, which he categorized as debt. He also concluded public enterprises did not endeavour to maximize profits in a competitive market and their managers did not have the motivation to respond to competition. (Kinyua, 2005) studied the impacts of capital structure of small and medium-sized enterprises in Kenya on its firm financial performance. In his study which covered five years, between 1998 and 2002, he used multiple regression and correlation to 22

33 analyse the collected data. He established that profitability, company size, asset structure, management attitude towards risk and lenders attitude towards the company are key impacts of capital structure for small and medium enterprises in Kenya. The study found a positive relationship between internally generated fund and the firm performance. (Matibe, 2005) set out to study the relationship between capital structure for listed companies in Kenya and their financial performance. The study covered five years, between 1998 and Correlation analysis was used to analyse the collected data. The study found out that firms owned by the state are more likely to borrow than those owned by individuals, institutions or foreign investors. He concluded that stateowned firms have more access to debt than firms owned by individuals and foreign investors. This study did not consider the effect of bankruptcy of organisation although it has indicated that there is a positive relation between leverage and firm performance. (Mustafa and Osama, 2006). The study investigated the effect of capital structure on the performance of the public Jordanian firms listed in Amman stock market. The study used multiple regression model represented by ordinary least squares (OLS) as a technique to examine what is the effect of capital structure on the performance by applying on 76 firms (53 industrial firms and 23 service corporation) for the period ( ). The results of the study concluded that capital structure associated negatively and statistically with firm performance on the study sample generally. In addition, the study found out that there was no significant difference to the impact of the financial leverage between high financial leverage firms and low financial leverage firms on their performance. 23

34 Finally, the study also showed that the effect of financial leverage on the basis of the growth that there is no difference between the financial leverage of high growth firms and low growth firms on the performance, which it was negatively and statistically. Although the study has illustrate that there was a positive relationship between leverage and firm s performance other factors like the asset structure and profitability were not factored in the study. (Osuji and Odita, 2010) did a study on impact of capital structure on financial performance of Nigerian firms using a sample of thirty non-financial firms listed on the Nigerian Stock Exchange during the seven year period, Panel data for the selected firms were generated and analysed using ordinary least squares (OLS) as a method of estimation. The result shows that a firm s capital structure surrogated by debt ratio has a significantly negative impact on the firm s financial measures (Return on Asset ROA). The study of these findings, indicate consistency with prior empirical studies and provide evidence in support of Agency cost theory. (Mwangi, 2010) did a study on capital structure on firms listed at the Nairobi Stock Exchange also tried to look on the relationship between capital structure and financial performance. Data was collected using structured questionnaires. The study identified that a strong positive relationship between leverage and return on equity, liquidity, and return on investment existed This hypothesis is also supported by a number of studies, to them the benefits of debt financing are less than it s negative aspects, so firms will always prefer to fund investments by internal sources (Jensen and Meckling, 1976) all found a significant and negative impact of capital structure on performance. 24

35 (Kehinde, 2012) in his study conducted between 2010 and 2012 examined the relationship that exists between the capital structure mix of the SMEs and the overall performance of the firm over the years in Nigerian. The study made use of questionnaire a survey method for data collection and chi-square a non-parametric method for data analysis. The study revealed that most SMEs have an all equity finance structure and has a less debt finance to equity finance. It also revealed that the earning, survival and growth of the SMEs is strongly influence by the capital structure mix. It was recommended that the government should design a home grown and SMEs friendly debt financing structure and managers of SMES should also seek professional advice when approaching financial institutions for debt finance. (Roshanak, 2013). The study of the Impact of Capital Structure Determinants on Small and Medium size Enterprise Leverage in Iran. The study used deductive approach with the unique set of data gathered from 201 SMEs in Iran over the period of 2006 to 2010, the statistic panel data regression is used to analyse the empirical data picked up from different manufacturing industries in Iran. The result of this research reveals that the impacts of capital structure determinants on SMEs leverage levels are different in terms of both magnitude and direction. The result indicates that profitability has a strong impact on SMEs borrowing decisions. Besides profitability, size and asset structure appear to have an impact on leverage level in compare with other determinants. The research finding shed lights on the necessity of using the maturity structure of debt (short-term debt and long-term debt) as dependent variables. Firms are more willing to finance their projects with short term debt, rather than long term debt. Long term debt is costly, and the probability of bankruptcy is higher with 25