Article 19 Effect of Financial Leverage On Financial Performance PDF
Article 19 Effect of Financial Leverage On Financial Performance PDF
Article 19 Effect of Financial Leverage On Financial Performance PDF
Abstract The aim of this study was an attempt to investigate the effect of financial leverage on financial
performance of deposit taking Saccos in Kenya. The sample data was extracted from 40 Savings and
Credit Co-operative Societies (Saccos) registered by Sacco Society Regulatory Authority (SASRA)
extended from the period 2010 to 2012. The secondary data used for analysis was collected from the
financial statements of the various deposit taking Saccos. Two basic approaches descriptive and
analytical design were adopted. The results show perfect positive correlation between debt equity
ratio with return on equity and profit after tax at 99% confidence interval and a weak positive
correlation between debt equity ratio with return on assets and income growth. As the scope of
study is limited to the deposit taking Saccos and the sample size is small, the findings of the study
must be interpreted with caution and the results may not be generalized to the Sacco sector. This is
the first study that examines the relationship between financial leverage on financial performance of
deposit taking savings and credit co-operative in Kenya.
Key words Financial Leverage, Financial Performance, Co-operatives, Saccos
1. Introduction
1.1. Background of the Study
In the quest to optimize their objective, which hinges primarily on quantifiable performance, financial
managers have adopted various capital structures as a means to that goal. A firm can finance its investment
by debt and/or equity. The use of fixed-charged funds, such as debt and preference capital along with the
owner’s equity in the capital structure is described as financial leverage or gearing (Dare and Sola, 2010). An
unlevered firm is an all-equity firm, whereas a levered firm is made up of ownership equity and debt. Financial
leverage takes the form of a loan or other borrowing (debt), the proceeds of which are (re)invested with the
intent to earn a greater rate of return than the cost of interest. If the firm’s marginal rate of return on asset
(ROA) is higher than the rate of interest payable on the loan, then its overall return on equity (ROE) will be
higher than if it did not borrow (Laurent, 2005). On the other hand, if the firm’s return on assets (ROA) is
lower than the interest rate, then its return on equity (ROE) will be lower than if it did not borrow. Leverage
allows a greater potential returns to the investor than otherwise would have been available, but the potential
loss is also greater: if the investment becomes worthless, the loan principal and all accrued interest on the
loan still need to be repaid (Andy et al., 2002). This constitutes financial risk (Pandey; 2005). The degree of
this financial risk is related to the firm’s financial structure. The total combination of common equity,
preferred stock and short and long term liabilities is referred to as financial structure. That is, the manner in
which the firm finances its assets constitutes its financial structure. If short-term liabilities are subtracted from
the firm’s financial structure, we obtain its capital structure. In other words, the firm’s permanent or long-
term financing consisting of common equity, preferred stock and long term debt is called capital structure
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(Van Horne, 2002). Hence, the objective of financial management in structuring a firm’s capital components is
to maximize the shareholders‟ wealth, as a measure of performance. Based on the above the problem of this
study is to analyze the implications of financial leverage on performance. Also considering that maximizing
accounting profit and maximizing shareholders‟ value are not identical because of shareholders‟ losses from
agency costs, it is therefore pertinent to see how capital structure affect shareholders‟ value.
situation is made worse by unstable Macro-economic environment coupled with stringent prudential
requirement on capital adequacy and liquidity standards. (Ongore et al., 2013) This study therefore, sought to
find out the effect of financial leverage on financial performance of Saccos in Kenya.
1.5. Justification
The study of capital structure is relevant to both researchers and managers. The major issues faced by
the finance managers are not only to receive or gather the funds but also their meaningful deployment in
order to generate maximum returns.
Mostly the sources of finance across all the businesses are same, then why some businesses succeed
while other doesn’t see the light of day. This clearly means that there is something beyond financial success of
business besides great idea and good geographic presence.
This makes it more attractive to study the effect of financial leverage on financial performance of
deposit taking Saccos in Kenya.
2. Literature Review
2.1. Theoretical Literature Review
2.1.1. The Trade-Off Theory
The term trade-off theory is used by different researchers to describe a family of related theories. A
decision maker running a firm evaluates the various costs and benefits of alternative leverage plans.
Frequently it is assumed that an interior solution is obtained so that marginal costs and marginal benefits are
balanced.
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The original version of the trade-off theory grew out of the debate over the Modigliani-Miller theorem.
When corporate income tax was added to the original irrelevance, this created a benefit for debt in that it
served to shield earnings from taxes. Given that the firm's objective function is linear, and there is no
offsetting cost of debt, this implied 100% debt financing.
Several aspects of Myers' definition of the trade-off merit discussion. Foremost, the target is not
directly observable. It may be imputed from evidence, but that depends on adding a structure.
Different papers add that structure in different ways.
Next, the tax code is much more complex than that assumed by the theory. Depending on which
features of the tax code are included, different conclusions regarding the target can be reached. Graham
(2003) provides a useful review of the literature on the tax effects.
Thirdly, bankruptcy costs must be deadweight costs rather than transfers from one claimant to another.
The nature of these costs is important too. Haugen and Senbet (1978) provide a useful discussion of
bankruptcy costs.
Fourthly, transaction costs must take a specific form for the analysis to work. For the adjustment to be
gradual rather than abrupt, the marginal cost of adjusting must increase when the adjustment is larger. Leary
and Roberts (2005) describe the implications of alternative adjustment cost assumptions.
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relationship with leverage at 99% confidence level, whereas liquidity and tangibility have significant
relationship with leverage at 95% confidence level.
Obradovich and Gill (2013) had researched on the Impact of Corporate Governance and Financial
Leverage on the Value of American Firms. For this purpose a sample of 333 firms listed on New York Stock
Exchange (NYSE) for a period of 3 years from 2009-2011 was selected. The co-relational and non-experimental
research design was used to conduct this study by taking firm value as dependent variable and CEO Duality,
Board Size, Audit Committee and Financial Leverage as dependent variable. The purpose of this study was to
find the impact of corporate governance and financial leverage on the value of American firms. Overall
outcomes show that larger board size negatively impacts the value of American firms and CEO duality, audit
committee, financial leverage, firm size, return on assets and insider holdings positively impact the value of
American firms.
Hasanzadeh et al. (2013) had investigated the Effects of Financial Leverage on Future Stock Value at
Stock Exchange. The research statistical population was consisted of those Tehran stock exchange listed active
cement industry companies analyzed from 2005 to 2008. By taking financial leverage and market to book
value ratio as variable and to analyze data and test hypothesis of the present research, descriptive and
inferential analyzing methods and SPSS statistical software were applied. They concluded that leverage does
not affect future stock value of the firm. The results indicate non-response of capital market against levered
nature of the firm. Lack of relationship between leverage and firm value approves net operational income
(NOI) theory and Miller and Modigliani (M.M) theory.
Akhtar et al. (2012) had investigated the impact of influence on shareholders return. In their paper
“Relationship between Financial leverage and Financial Performance: Evidence from Fuel & Energy Sector of
Pakistan, they demonstrated that financial leverage has got a positive relationship with financial
performance”. Hence, the companies in the fuel and energy sector may enhance their financial performance
and can play their role for the growth of the economy while improving at their optimal capital structures. In
their study they employed a sample of 20 listed public limited companies from Fuel and Energy sector listed at
Karachi Stock Exchange (KSE). The study aimed at measuring the relationship between financial leverage and
the financial performance. To test the hypothesis, the main variables used in the study consist of a dependent
variable which is financial performance of fuel and energy sector while an independent variable financial
leverage in fuel and energy sector.
Akinmulegun Sunday Ojo (2012) in his paper “The Effect of Financial Leverage on Corporate
Performance of Some Selected Companies in Nigeria empirically examines the effect of financial leverage on
selected indicators of corporate performance in Nigeria”. Leverage therefore significantly affects corporate
performance in Nigeria. Other detailed objectives are to: Examine the impact of leverage on the earnings per
share and net assets per share of corporate firms in Nigeria. The econometric findings presented in this study
evidence that leverage shocks (debt/ equity ratio) have significant effect on corporate performance especially
when the net assets per share (NAPS) is used as an indicator of corporate performance in Nigeria over the
period covered by the study. Earnings per share depend on feedback shock and less on leverage shock. Also,
the outcome exposed that the influence shock on earnings per share indirectly disturb the net assets per
share of firms as the majority of the shocks on the net assets per share was received from earnings per share
of the firms.
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2.3.2. Conceptualization
Independent Variables Dependent Variables
Financial Leverage Financial Performance
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desired form and entered into SPSS version 21. Data analysis was then conducted to generate descriptive and
correlations output. These results are as shown in the proceeding sections.
In table 2 statistical analysis of financial performance indicator is shown. The maximum value of return
on equity is 79.57 while the minimum value is .04 while the average for the industry is 9.2775 with a standard
deviation of 17. 94284. The maximum value of return on assets is 23.61 while the minimum value is .49 while
the average for the industry is 12.6223 with a standard deviation of 5.40236. The maximum value of income
growth is 14.20 while the minimum value is -13.15 while the average for the industry is 4.5250 with a
standard deviation of 4.94188. The maximum value of profit after tax is 2,290,717,472.00 while the minimum
value is 4,880,461.00 while the average for the industry is 239,802,837.80 with a standard deviation of
417,890,981.35.
Table 3. Correlations analysis of financial performance indicators with Debt Equity Ratio
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