The effect of financial leverage on profitabilty and risk of firms listed at the Nairobi securities exchange

Abstract

The objective of the study was to establish the effect of financial leverage on profitability and risk of firms listed at the Nairobi Securities Exchange (NSE) for the periods 1 January 2007 to 31 December 2011. A casual research design was adopted for the study. Population consisted of fifty eight companies out of which thirty companies were sampled. Sample exclude fifteen companies listed under banks and insurance because these companies are regulated and are to meet certain liquidity and / or leverage ratios. Six companies were suspended. Three companies were newly listed and therefore not continuously listed over the period of study. Four companies had information missing for some years required for the computation of the variables. Secondary data was used and data collected from the thirty companies sampled. Source data included NSE database, Capital Markets Authority (CMA) and Annual Audited Financial Statements of sampled companies. Data was analyzed using Statistical Packages for Social Sciences (SPSS) version 17. Cross-sectional time series fixed model was used with the regression and correlation analysis to determine the nature and the strength of the relationship between the independent and dependent variables. Based on the regression and correlation analysis, the findings of the first model indicated that 14.2% of variation in profitability was explained by financial leverage and there existed a negative relationship. This means that for every 1% change increase in financial leverage, there is a 14.2% decrease in profitability and vice versa. The second finding showed that 23.5 % variation in risk was explained by financial leverage and there existed a positive relationship. Meaning that as financial leverage increases by 1%, risk increases by 23.5%. The third finding indicated a 3% variation of returns adjusted by risk being explained by financial leverage and there existed a negative relationship. As financial risk increases by 1%, returns adjusted by risk decreases by 3% and vice versa. This indicates an insignificant relationship between returns adjusted by risk and financial leverage. The findings of the study did not reveal what was expected. The expectation was that financial leverage has a strong positive effect on profitability and risk. The results however are not inclusive but they lay foundation for potential future research and useful recommendations for the policy direction. The study has also highlighted some of the limitations encountered.