A Sectoral Analysis of the Relationship Between Financial Leverage and Profitability of Nonfinancial Firms Listed at the Nairobi Securities Exchange

Abstract

The debate on what is the best source of business financing and its impact on firm’s financial performance has remained a controversial topic from the time when Modigliani & Miller published their seminal work on this topic way back in 1958. The paper suggested that the source of capital has no impact on firm value and performance. Many research studies have since been conducted on the topic resulting in varying and contradicting conclusions hence the un-ending discussion on the topic. The objective of this research study was to determine the relationship between leverage and profitability of NSE listed non-financial firms at a sectoral level. Profitability was measured by return on asset while leverage was measured using long term debt divided by total equity. The research period was 2013-2017. The study population comprised of 36 non-financial firms that were listed for the full period of study at the NSE. For the consistency of data, the research excluded firms that were suspended, delisted or those that got listed within the period of study. The 36 firms were categorized into 8 sectors, namely Agricultural, Automobile & Accessories, Commercial & Services, Construction, Energy, Investment, Manufacturing and Telecommunication sectors. Secondary data was used in executing the study and was obtained from the annual financial reports of the firms accessed from the websites of the respective firms as well as from the NSE Handbooks covering the period 2013 to 2017. The research applied the correlation and regression analysis to perform statistical analysis with the use of Statistical Package for Social Sciences (SPSS). The study findings show that there are varying relationships between leverage and profitability from one sector to another. The study found positive relationship between leverage and profitability for firms listed under the Commercial & Services sector, Investment sector and Energy & Petroleum sector. Therefore, the study recommends that the managers of firms under these sectors should consider increase the debt levels in their capital structures as compared to equity injection to enable them improve their profitability. Debt financing has tax shield benefits that help boost the profitability of firms. The research findings showed negative relationship between leverage and profitability for firms listed under Construction, Manufacturing, Automobile and Agricultural sectors. It is therefore recommended that, based on this finding, the managers of firms operating under these sectors should focus on reducing the level of leverage or apply debt use sparingly in order to improve the profitability of their respective firms. Debt finance carries with it the interest cost as well as restrictive covenants which may exceed the debt benefits.