The effect of capital structure on profitability of non-financial firms listed at Nairobi security exchange

Abstract

Good capital structures are critical for the survival of any business firms in any economic arrangement or set up. The current study’s purpose was to investigate the effect of capital structure on profitability of non-financial firms listed at Nairobi Stock Exchange (NSE). The study tested the null hypotheses that there is no relationship between short term debt-equity ratio, long term debt-equity ratio and equity on profitability of non-financial firms listed at NSE. The theoretical basis of the study was on agency theory, static trade off theory, pecking order theory and MM capital structure irrelevance theorem. Descriptive research design was applied in this research study. The study applied the epistemology philosophy based on positivist paradigm. The target population for this study was all the listed non-financial firms in the NSE as at 31st March 2015. Data for these 41 companies for five years (2010 – 2014) was used in the study. Secondary data applied in this study was collected from the audited financial statements of the companies, NSE and the Capital Markets Authority. Panel data regression (fixed effects) model was applied in analysis. Stata statistical software was utilized. The study findings indicate that short term debt equity ratio negatively and significantly affects ROA, ROE and ROCE. Long term debt equity ratio has a negative effect on return on assets and return on equity but has an insignificant effect on ROCE. Equity has a positive and significant relationship with ROE and ROCE but has an insignificant effect on ROA. The following recommendations are made. First, though short term debt is a source of quick liquidity for the firm during emergencies, they bring shocks and added riskiness to the firm and hence managers should apply these sources of financing with caution. Secondly, managers should establish the level of debt of debt to equity that is optimum for the firm and seek to achieve this optimum level. Firms should however, mostly rely on retained earnings for expansion and growth. Thirdly, the study recommends that managers in non-financial firms should effectively manage the amount of borrowed capital in the firms’ capital structure since high debt levels will mean more interest payments and thus cash outflows.