The relationship between capital structure and profitability of listed non financial firms in Kenya

Abstract

Capital structure decision is the vital one since the profitability of an enterprise is directly affected by such decision. The determination of a company’s capital structure constitutes a difficult decision, one that involves several and antagonistic factors, such as risk and profitability. That decision becomes even more difficult, in times when the economic environment in which the company operates presents a high degree of instability. A review of empirical works reveals that there exists conflicting results about the relationship between capital structure and profitability of companies. Some studies found a negative relationship between profitability and leverage while others observed a positive relationship between profitability and debt levels in their studies. The objective of this study was to investigate the relationship between capital structure and profitability of listed non financial firms in Kenya over the 5 year period from 2008 to 2012 after the financial crisis of 2007. The study adopted a descriptive research design. The target population of this study comprised of all the 40 listed non financial firms. A census was carried out due to the small number of non financial firms in Kenya. The study used secondary data extracted from annual financial reports. Descriptive data analysis techniques and regression were used to analyse the data. The long-term liability to equity indicated an inverse relationship to profitability at -5.70%, with an adjusted coefficient of determination of 97.80%. The study also found that the firm’s profitability (measured by return on equity) was positively correlated with the short-term debt at 18.10% and longterm debt (LP/PL) at 56.20%. The study concludes that there is a negative relationship between capital structure and profitability. The results are in line with the pecking order theory and information asymmetrical theory. The study recommends that firm’s should aim to attain a debt/equity ratio, which will minimize the cost of capital and increase the profitability of firms. The top management of every firm should make prudent financing decisions in order to remain profitable and competitive. Further research could also be undertaken to examine capital structure and profitability of non listed firms in Kenya. Further investigation is required to examine what factors other than capital structure influence profitability.