The Relationship Between Corporate Financial Performance and Financial Leverage for Non-financial Firms Listed at the Nairobi Securities Exchange

Abstract

We all engage in investment activities in the hope that by so doing we will increase our wealth. Financial performance of a firm is driven by operating decisions such as use of debt aimed at efficient and effective use of its assets to increase profits. Divergent opinion has risen as to the impact of debt on financial performance of corporations with some practitioners and researchers holding that use of moderate debt will increase profitability while others have argued that debt is irrelevant to firm performance. Worldwide empirical studies have returned varied results as to whether a relationship exists amid leverage and financial performance. Recent studies undertaken in Kenya using data from the NSE have registered positive, negative and no relationship. A question therefore arises, why the difference? Employing a causal study design, for the period between 2006 and 2015 and focusing on different levels of profitability for Kenyan listed non-financial firms, utilizing secondary quantitative data and a of sample of 31 firms, the study set to establish the relationship amid corporate financial performance and leverage. Three groups; the highly profitable, the moderately profitable and the least profitable comprising firms ranked based on their average return on equity over the study period represented the different levels of profitability. The research finds that the highly profitable firms at the NSE ascribe to a tradeoff model, and that firms can accrue benefits by employing debt which the managers for these firms deliberately seek to utilize until an optimal leverage is attained. For the highly profitable firms, contradictory results (positive and negative relations) may be observed in studies undertaken between 2006 and 2009 and between 2010 and 2015. This is because as revealed by trend analysis, profitability peaked at about 2009 and 2010 and declined thereafter to 2015. Wrong conclusions may be arrived at for the highly profitable firms at the NSE if literature is applied that indicates that characteristics of firms that prescribe to a pecking order include high profitable, low relative debt, negative relationship amid corporate financial performance and leverage. The study recommends exclusion of the least profitable firms at the NSE from capital structure studies as they largely don’t pay income taxes and hence have no tax shield to benefit from.