An empirical investigation into the relationship between gearing and profitability of firms listed on NSE

Abstract

This Study sought to investigate the relationship between gearing and profitability of listed firms on the Nairobi Stock Exchange (NSE) during a six-year period. Data was collected from Nairobi Stock Exchange, Capital Markets Authority and from the Registrar of Companies. The data was extracted from the financial statements of those companies that were consistently listed in NSE for the years 2000 to 2006. The data that was extracted were revenue (sales), gross profit, reserves, total shareholders equity, EBT, EBIT, net income, minority interest, long term liabilities, long term liabilities (interest bearing). It was only the basis of these data that paid up capital, capital employed and return on capital employed were derived. The secondary data collected was then used to compute profitability and gearing ratios. Regression analysis was used in the estimation of functions relating the operating profit margin (OPM) with measures of gearing. This finding can be considered as an indication that firms generally finance their activities following the financing procedure implied by the pecking order theory. The findings were thus consistent with the pecking order theory that denotes that firms prefer internal financing from external. The results reveal an insignificant negative relation between gearing ratios and profitability. The research suggests that profitable firms depend less on debt as a financing option. In the Kenyan case, there seems apparent that there are other factors that determine the firm gearing levels other than profitability.