The Effect of Financial Leverage on Profitability of Commercial Services Firms in Nairobi Securities Exchange

Abstract

The objective of any company in business is to ensure it maximizes the wealth of its shareholders. With this aim in mind, the shareholders select and appoint a board of management that is tasked with overseeing the company’s operations and ensuring that that the firms’ capital structure financial components (debt and equity) are optimally utilized for growth of the company. Optimal capital structure decision should thus be made to maximize firm value, as outlined by Pandey (2005) who further stated that if the capital structure decision of a company could affect its value, then it would be imperative for the firm to have an equity and debt mix which maximized its market value. Debt can be loans, debentures, or leases while equity can be categorized as retained earnings, common or preferred stock. In maximization of shareholders’ wealth, firms use more debt to maximize on the interest tax benefits offered by debt. Equity shareholders however don’t have to share their profits with debt holders because the latter get a fixed return. However, taking up high debt capital increases the credit risk of the firm and makes it susceptible to bankruptcy. This research was done to examine the impact that a firm’s financial leverage has on profitability of commercial and services firms that are quoted at the NSE. Anchoring theories of the research were the Pecking Order, Modigliani-Miller and the Trade-off theories. ROA was used to calculate the financial performance of the firms. Financial leverage was derived from the debt-to-equity ratio. The study used a census survey because of the small population size. All the 12 companies from the commercial and services firms sector listed in the NSE were studied. Collection of secondary data was from annual financial reports published and the data analyzed by using the XLSTAT and SPSS software through correlation, regression analysis and descriptive statistics method. The findings of the study found out that there was no significant relationship between ROA and the firms’ financial leverage. The study also established that there was a positive link between firm size and ROA and a linear association between ROA and liquidity. The study recommends that firms should optimally strike a balance when choosing the capital structure strategies by maximizing on debt tax-shield benefits and reducing distress costs that are associated with heavy borrowing. Additionally, the study recommends that companies should maintain ample liquidity levels which will enable them to cover their operational expenses and meet their obligations as study findings depicts a positive association between firm liquidity and financial performance of the firms.