Capital Structure Impact On The Performance Of Banking Industry In Nigeria

Project and Seminar Material for Economics

Abstract

There exists divergence of opinion in literature on the relationship between capital structure and firms financial performance. This mix of opinions makes the direction of the relationship between debt holders and equity holders to be controversial. Therefore, this study investigated the impact of capital structure on the performance of banking industry in Nigeria. The study formulated four hypotheses and used generalized least square multiple regression to analyze the secondary data extracted from the annual reports and accounts of the sampled banks for the period 2014 to 2019. The study found that total debt, long-term debt and short-term debt have significant impact on the financial performance of banks in Nigeria. The study also found that total debt to total equity has no significant effect on the financial performance of the firms. In view of the findings, it is recommended among others that the management of banks should work very hard to increase the short term debt to total assets component of their capital structure, since it has positive impact on their financial performance. Also, the banks should reduce the level of total debt to total assets and long term debt to total assets in their capital structure components, because they affect their financial performance negatively.

Table of Content

Chapter One

1.0 Introduction

1.1 Background to the Study
1.2 Statement of the Problem
1.3 Objectives of the Study
1.4 Research Question
1.5 Research Hypothesis
1.6 Significance of the Study
1.7 Scope of Study
1.8 Limitation of the Study
1.9 Definition of Terms
1.10 Organisation of the Study

Chapter Two

2.0 Literature Review

2.1 Conceptual Framework
2.2 Concept of Capital Structure
2.2.1 Total Debt to Total Assets
2.2.2 Total Debt to Total Equity
2.2.3 Short Term Debt to Total Assets
2.2.4 Long Term Debt to Total Assets
2.2.5 Equity
2.3 Concept of Financial Performance
2.4 Theoretical Framework
2.4.1 Efficiency-Risk Hypothesis
2.4.2 Franchise-Value Hypothesis
2.4.3 The Agency Cost Theory
2.5 Review Of Empirical Studies
2.5.1 Total Debt to Total Assets And Financial Performance
2.5.2 Total Debt to Total Equity And Financial Performance
2.5.3 Short Term Debt to Total Assets and Financial Performance
2.5.4 Long-Term Debt to Total Assets and Financial Performance

Chapter Three

3.0 Research Methodology

3.1 Research Design
3.2 Population
3.3 Sources and Method of Data Collection
3.4 Technique of Data Analysis
3.5 Variables Measurement
3.6 Model Specification
3.7 Diagnostic and Robustness Tests

Chapter Four

4.0 Results and Discussion

4.1 Result
4.2 Descriptive Statistics
4.3 Correlation Matrix
4.4 Analysis of Regression Results
4.5 Discussion of Findings

Chapter Five

5.0 Summary, Conclusion and Recommendation

5.1 Summary
5.2 Conclusion
5.3 Recommendation
References

Chapter One

1.0 Introduction

1.1 Background to the Study

The nature and extent of relationship between capital structure and financial performance of firms have attracted attention in the literature of finance. Capital structure involves the decision about the combination of the various sources of funds a firm uses to finance its operations and capital investments. These sources include the use of long-term debt finance called debt financing, as well as preferred stock and common stock also called equity financing. One of the most important goals of financial managers is to maximize shareholders wealth through determination of the best combination of financial resources for a company and maximization of the company’s value by determining where to invest their resources.

Capital structure represents the major claims to a corporation’s asset. This includes the different types of equities and liabilities (Riahi-Belkaoui, 1999). The debt-equity mix can take any of the following forms: 100% equity: 0% debt, 0% equity: 100% debt; and X% equity: Y% debt. From these three alternatives, the first option is that of the unlevered firm, that is, the firm shuns the advantage of leverage (if any). Option two is that of a firm that has no equity capital. This option may not actually be realistic or possible in the real life economic situation, because no provider of funds will invest money in a firm without equity capital. This partially explains the term “trading on equity”, that is, the equity element that is present in the firm‟s capital structure that encourages the debt providers to give their scarce resources to the business. The third Option is the most realistic one in that, it combined both a certain percentage of debt and equity in the capital structure and thus, the advantages of leverage (if any) is exploited. This mix of debt and equity has long been a subject of debate in finance literature concerning its determination, evaluation and accounting.

Financial performance is the measure of how well a firm can use its assets from its primary business to generate revenues. Erasmus (2008) noted that financial performance measures like profitability and liquidity among others provide a valuable tool to stake holders which aids in evaluating the past financial performance and current position of a firm. Financial performance evaluation are designed to provide answers to a broad range of important questions, some of which include whether the company has enough cash to meet all its obligations, is it generating sufficient volume of sales to justify recent investment. Capital structure is closely linked with financial performance (Tian and Zeitun, 2007). Financial performance can be measured by variables which involve productivity, profitability, growth or, even, customers‟ satisfaction. These measures are related among each other. Financial measurement is one of the tools which indicate the financial strengths, weaknesses, opportunities and threats.

Those measurements are return on investment (ROI), residual income (RI), earning per share (EPS), dividend yield, return on assets (ROA),, growth in sales, return on equity (ROE),e.t.c (Stanford, 2009).

One of the main factors that could influence the firm’s performance is capital structure. Since bankruptcy costs exist, deteriorating returns occur with further use of debt in order to get the benefits of tax deduction and interest. Therefore, there is an appropriate capital structure beyond which increases in bankruptcy costs are higher than the marginal tax-sheltering benefits associated with the additional substitution of debt for equity. Firms are willing to maximise their performance, and minimise their financing cost, by maintaining the appropriate capital structure or the optimal capital structure.

Previous studies on capital structure have used different proxies to measure capital structure. The measures commonly used in the literature in form of ratios include total debt to total assets, total debt to total equity, short term debt to total assets and long term debt to total assets. Total debt to total assets is the amount of debt used to finance firms‟ assets and other capital expenditure that can improve firms‟ performance. Thus, it is expected that increasing leverage components of a firm‟s capital structure may increase the level of efficiency and thereby increasing their performance. Company‟s managers who are able to identify the level of leverages as components of firms‟ capital structure are rewarded by reducing firm‟s cost of finance thereby maximizing the firm‟s revenue (Zeitun&Tian, 2007). Total debt to total assets measures the amount of the total funds provided by outsiders in relation to the total assets of the firm. It shows the extent of cover for debts of a company by total assets. It described the extent to which a business or investor is using the borrowed money. Generally, investors would prefer low ratio for all debts, because the lower the ratio the better the cushion against the creditors losses in the event of liquidation. Most firms use debt to finance their operation with the hope of improving their performance. By doing so, a company increases its leverage because it can invest in business operations without increasing its equity.
Total debt to total equity is also expected to have an influence on a firm’s performance. Total debt to total equity assesses the extent to which a firm is using borrowed funds. It shows the extent to which a firm is using borrowed funds in relation to its equity. It indicates the solvency of the business and the extent of cover for external liabilities. It also measure of a company‟s financial leverage calculated by dividing its total liability, by stockholders equity, it indicates what proportion of equity and debt a company is using to finance its assets (Ojo, 2012). Total debt to total equity is a measure of how much firm uses equity and debt. Investors prefer the ratio to be lower; because the lower ratio the higher the level of firms financing that is being provided by shareholders and the larger the cushion (margin of protection) in the event of shrinking asset values or outright losses. From the creditor‟s point of view, it is possible that debt to equity helps in understanding business risk management strategies and how firms determine the likelihood of default associated with firms‟ financial performance (Kurfi, 2003). Semiu and Collins (2011) see equity capital as including share-capital, share premium, reserves and surpluses (retained earnings).

Short term debt to total assets is another item in a firm‟s capital structure that affects its financial performance. Short term debts to total assets affect the financial performance of a firm either negatively or positively. Short-term debt to total asset measures the relative short-term debts to total assets of a firm are to meet it financial obligation over the accounting period. Some scholars argue that the shorter the debt the better the firm is in improving its performance.

Understanding the relationship between long term debt to total assets and performance of various sectors of an economy is important to all stakeholders. Long-term debt to total assets measures the relative weight of long-term debt to the capital structure (long-term financing) of the firm in long run. The level of long-term debt of a firm is also believed to be one of the forces expected to influence the performance of a firm. A firm that has a higher long-term debt as proposed by previous studies would have little resources to take care of some other objectives and vice versa (Kurfi, 2013).

As financial capital is an uncertain but critical resource for all firms, providers of finance are able to exert control over firms. Debt and equity are the major classes of capital structure, with debt holders and equity holders representing the two types of investors in a firm. Each of them is associated with different levels of control, benefits and risk. While debt holders exert lower control, they earn a fixed rate of return and are protected by contractual obligations with respect to their investment. Equity holders are the real owners of a firm, bearing most of the risk and correspondingly, have greater control over decisions (Aliu, 2010).

The use of debt in an organizations capital structure has both positive and negative effects on its financial performance. Organizations that use an optimum amount of debt in their capital structure have enhanced firm value which is manifested in the form of increased sales, efficiency in production and low taxes. While firms with different cases of sub optimal use of debt in their capital structure usually suffer from a variety of financial ailments which Rajan and Zingales (1995) described as payment of high taxes, high proportions of accounts payable, large deficits in the firms cash flow and in some cases corporate dissolution. Accordingly Modigliani and Miller (1963) suggested that firms should incorporate more debt in their capital structure in order to maximize the firm’s value which is manifested through high profits, increased share prices and efficiency in management.

The capital structure theory originated from the famous work of Modigliani and Miller (M & M) (1958). They argued that, under certain conditions, the choice between debt and equity does not affect a firm’s value and hence, the capital structure decision is irrelevant; but in a world with tax-deductible interest payment, firm value and capital structure are positively related. M & M (1958) pointed out the direction that capital structure must take by showing under what conditions the capital structure is irrelevant. Titman (2001) lists some fundamental issues that make the M & M proposition hold as: no taxes, no transaction cost, no bankruptcy cost, perfect contracting assumptions and complete and perfect market assumption. The M & M presentation became a subject of considerable debate both in theoretical and empirical research. The work of M & M has been criticized by many scholars in view of the fact that in the real world situation, the main assumptions never hold. They argued that in a “non-perfect” world, there are factors influencing capital structure decision of a firm.

Since the presentation of M & M‟s irrelevance propositions, a lot of issues have been raised with respect to capital structure. Many researchers have attempted to establish whether their theory is realistic and capable of resolving basic financing decision problems regarding optimal capital structure for individual firm and the effect of an appropriate financing mix on firm performance and in what condition is the choice of capital structure relevant (Aliu 2010). Their studies however, have provided different opinion on the direction of their association. The mixed and inconclusive findings provided motivation for further studies in this area to determine whether capital structure has an influence on financial performance of firms in different sectors of the economy.

The fact that banks in Nigeria frequently use leverage to finance their operation through debt or equity or both, the extent to which capital structure affects their operation has been an issue of concern. It has been argued that the fastest trend through which a nation can achieve sustainable economic growth and development is neither by the level of its endowed material resources nor that of its vast human resources but technological innovation, enterprise development and industrial capacity. In the modern world, banking industry is regarded as a basis for determining a nation economic efficiency.

Arising from the strategic importance of the banking industry to an economy such as Nigeria’s, it is important for investors and shareholders to understand the effect of capital structure on the performance of banks. This is because capital structure decision on how to finance their assets by debt or by equity will affect relationship with the final result for any given period since it influences the returns and risks of shareholders and consequently affects the market value of the shares. In view of this, it becomes imperative to study capital structure impact on the performance of banking industry in Nigeria.

1.2 Statement of the Problem

There has been an ongoing debate on the issue of capital structure and financial performance of firms. This controversy is further narrowed down to identifying which of the variables debated is most influential in predicting and determining the capital structure of banks. The choice of optimal capital structure of a firm is difficult to determine. A firm has to issue various securities in a countless mixture to come across particular combinations that can maximize its overall value which means optimal capital structure. Optimal capital structure also means that with a minimum weighted-average cost of capital, the value of a firm is maximized. According to Rahul (1997), poor capital structure decisions may lead to a possible reduction in the value derived from strategic assets. Hence, the capability of a company in managing its financial policies is important if the firm is to realize gains from its specialized resources. The nature and extent of relationship between capital structure and financial performance of firms have attracted the attention of many researchers. The studies, which are largely foreign based, have however revealed conflicting findings.

In Nigeria, most of the studies did not use other components on capital structure and financial performance. The studies which include Bello and Onyesom (2005), Salawu (2007), Olokoyo (2012), Babalola (2012), Yinusa and Babalola (2012), Sabastian and Rapuluchukwu (2012) and Idode, Adeleke, Ogunlowo and Ashogbon (2014) have left a gap that need to be filled. For example, Salawu (2007), who studied the effect of capital structure on financial performance of selected quoted companies in Nigeria between 1990 and 2004 concentrated on short term debt. His study did not extend to other forms of financing, thus the finding could only be used in the context of short term debt financing. This means even within the purview of debt financing; only the short term aspect of the debt was covered in his study. In reality, a study on capital structure is supposed to cover both types of debt financing.

Babalola (2012) who also studied the effect of optimal capital structure on firm‟s performance in Nigeria between 2000 to 2009 using samples of 10 firms, concentrated on total debt to total assets. His study excluded the aspect of total debt to equity, short term debt to total assets and long term debt to total assets financing despite the fact that both types of debt financing are used by the sampled firms. More so, his study and those of Bello and Onyesom (2005) and Olokoyo (2012) used Chi-square technique to analyze their data. Chi-square is considered deficient in terms of reflecting time variant and specific characteristic issues. Studies on capital structure and performance of firms are supposed to use parametric techniques that measure both time variant and specific characteristic issues.
Furthermore, the study of Yinusa and Babalola (2012) examined the impact of corporate governance on capital structure decision of ten (10) firms in the food and beverage sector during the period from 2000 to 2009. They used total debt to total assets ratio as proxy of capital structure. The study did not cover other components or types of debt financing such as total debt to total equity, short- term debt and long-term debt. Additionally, Sebastian and Rapuluchukwu (2012) that studied the impact of capital structure and liquidity on corporate returns of banks between 2002 to 2006, focused on short-term debt, long-term debt and total debt without including total debt to total equity financing. The study failed to use total debt to total equity as variable of debt financing. Idode, Adeleke, Ogunlowore and Ashogbon (2014) in their study of the influence of capital structure on profitability of banks in Nigeria for the period of 2008 to 2012 covered both debt financing and equity financing. However, they ignored short-term debt and long-term debt which constitute other important forms of financing for manufacturing companies in Nigeria.

Owing to these identified gaps, a study that will cover the various forms of financing mix in order to address the following questions that remain unanswered is desirable: to what extent do total debt to total assets ratio, total debt to total equity ratio, and the ratios of short-term and long term debt to total assets affect the performance of banks in Nigeria? This study attempts to provide answers to this fundamental question.

1.3 Objectives of the Study

The aim of this study is to examine the impact of capital structure on the performance of banking industry in Nigeria.

Specifically, the objectives of the study include to;

Evaluate the extent to which total debt to total asset ratio affect performance of banks in Nigeria
Determine the effect of total debt to total equity ratio on performance of banks in Nigeria
Examine the impact of short-term debt to total assets ratio on performance of banks in Nigeria
Assess the influence of long-term debt to total assets ratio on performance of banks in Nigeria.

1.4 Research Question

The following research questions are formulated to guide this research:

What is the extent to which total debt to total asset ratio affect performance of banks in Nigeria?
What is the effect of total debt to total equity ratio on performance of banks in Nigeria?
What is the impact of short-term debt to total assets ratio on performance of banks in Nigeria?
What is the influence of long-term debt to total assets ratio on performance of banks in Nigeria?

1.5 Research Hypothesis

H01: Total debt to total assets ratio has no significant impact on performance of banks in Nigeria.
H02: Total debt to total equity ratio has no significant impact on performance of banks in Nigeria.
H03: Short-term debt to total assets ratio has no significant impact on performance of banks in Nigeria.
H04: Long-term debt to total assets ratio has no significant impact on performance of banks in Nigeria.

1.6 Significance of the Study

The outcome of this study would contribute to the existing body of knowledge. Because, though there are a lot of studies on capital structure and financial performance around the globe, there is dearth of evidence using data on banks in Nigeria. The outcome of the study would therefore serve as a reference material for subsequent researchers and would provide a basis for further research in this area.

It is the hope that the result of this study will be beneficial to both internal and external parties (i.e. managers in maximizing investors return, owners in making an informed decision, creditors in ascertaining credit worthiness of a firm, Government in making favorable financing policies etc.) to improve on the GDP contribution by the banking industry and also improve on employment rate once the sector is viable since the stake holders are interested in knowing the impact of such decisions on an organization performance.

Also, the government and its agencies will somehow benefit from this study because the study will highlight the need from its findings if necessary for the government to formulate more favorable financial and economic guidelines as the sector demands and this will sustain the operations of Nigerian Banks, especially the potential firms yet to be quoted in the stock market and resultantly contributing to GDP of the nation which have been on the decline hitherto.

The results of this study would also be of benefit to managers, shareholders and creditors of banks in Nigeria. Managers would be placed on a sound footing to understand the effect of various financing mix on the operations of their firms.

Shareholders would be able to make an informed decision with regard to their equity interest in relation to the debt financing options available to their firms, while creditors would be able to identify the firms that are financially strong enough to settle their claim as at when due.

1.7 Scope of Study

The study is designed to examine the impact of capital structure on the performance of banking industry in Nigeria. The study covers the period of six (6) years from 2014 to 2019. The study chooses the banking industry as its domain because it covers the larger proportion of the financial sector in Nigeria. The independent variables of the study are capital structure proxied by total debt to total assets, total debt to total equity, short-term debt to total assets and long-term debt to total assets, and the dependent variable is represented by financial performance proxied by return on assets. The period of the study is considered appropriate because it coincides with the period within which major reforms took place in the banking industry.

1.8 Limitation of the Study

In the course of this study, the researcher encountered some limitations. There was paucity of data relevant to the completion of this work, hence, the researcher had to make use of secondary data sources that were verified and approved for use such as the National Bulleting of Statistics, the Central Bank of Nigeria and the individual bank reports. Also, the researcher faced time constraints and had to combine the research with other academic activities and coursework. Also, the study considered only four proxies of capital structure without considering other proxies that determine capital structure such as short term debt to total equity and long term debt to total equity. The result may be different if other variables were to be added.

1.9 Definition of Terms

Capital Structure:

Refers to the specific mix of debt and equity used to finance a company’s assets and operations. From a corporate perspective, equity represents a more expensive, permanent source of capital with greater financial flexibility.

Performance:

Is a composite assessment of how well an organization executes on its most important parameters, typically financial, market and shareholder performance. It also comprises the actual output or results of an organization as measured against its intended outputs (or goals and objectives).

Banking Industry:

Is a network of financial institutions licensed by the state to supply banking services.

Bank:

Is a financial institution licensed to receive deposits and make loans. Banks may also provide financial services such as wealth management, currency exchange, and safe deposit boxes. There are several different kinds of banks including retail banks, commercial or corporate banks, and investment banks.

1.10 Organisation of the Study

This study is organized into five chapters. Chapter one included the background of the study, research problem, research objectives and questions as well as limitation of the study. Chapter two contains the literature review. Chapter three includes the methodology. Chapter Four contains the results and discussion of key findings of the study. Chapter Five finally looks at the summary, conclusions, and recommendations based on the findings.

Chapter Five

5.0 Summary, Conclusion and Recommendation

5.1 Summary

This study was conducted to examine the impact of capital structure on the performance of banking industry in Nigeria. The study was divided into five chapters. The first chapter discussed the background issues, which led to developing four objectives and formulating four hypotheses for the research with a scope covering six (6) years, from 2014 to 2019. The review of conceptual literature and empirical studies on capital structure and financial performance was carried out. Also, the concept and measurement of firm performance was discussed as well as the review of the relationship between each of the proxies of the independent variables and the dependent variable. The theoretical framework that underpinned the study was also discussed.

Correlation research design was used in measuring the relationship among the variables of the study. Data was collected from secondary source through the annual reports and accounts ofsampled banks that have complete financial records either on their website or in the office of the Central Bank of Nigeria. Multiple regression was used to test the four hypotheses formulated by the study. The result of the descriptive statistics, correlation matrix and regression were presented, analysed and discussed in chapter four. The regression result could not provide sufficient evidence for the rejection of hypotheses two that hypothesized that total debt to total equity ratios have no significant impact on the financial performance of banks in Nigeria. The result however provided sufficient evidence for rejecting the first, third and fourth hypotheses on total debt to total asset, long term debt to total assets and short term debt to total assets ratios. Finally, the chapter discussed the findings of the research in light of previous studies and highlighted the policy implications of the findings.

5.2 Conclusion

As a corollary of the discussion and analysis in the preceding chapter, the study concludes as follows:

Firstly, the study found a negative significant association between total debt to total assets ratio and financial performance. It is therefore concluded that total debt to total asset is one of the variable of capital structure that contribute in influencing financial performance of the banking industry in Nigeria.

In addition, the study found a negative insignificant association between total debt to total equity ratio and financial performance of banks in Nigeria. Thus, the study concluded that total debt to total equity is not one of the factors that influence the financial performance of banks in Nigeria.

Furthermore, long-term debt to total assets ratio was found to have negative significant impact on financial performance of banks in Nigeria. The study therefore, concluded that long-term debt to total assets ratio is one of the strong determinants of the financial performance of banks in Nigeria.

More so, the study found a positive significant relationship between the ratio of short-term debt to total assets and the financial performance of banks in Nigeria. Thus, the study concluded that short- term debt to total asset is amongst the determinants of the financial performance of banks in Nigeria.

5.3 Recommendation

Based on the findings of this study, the following are recommended;

The management of the Nigerian banking industry should work very hard to optimize the capital structure of their banks in order to increase the financial performance. They can do that through ensuring that their capital structure is optimal.
The Management of the Nigerian banking industry should increase their commitments into short term debt to total asset in order to improve financial performance from their business operation. This is in line with the findings of this study that the short term debt of banks in Nigeria influences their financial performance positively.
The Management of the Nigerian banking industry should be concerned about the level of their total debt to total equity, for better financial performance. This is because the findings of this study revealed a negative insignificant relationship the variables and financial performance.
Stakeholders of banking industry in Nigeria should also reduce the level of total debt to total assets and long term debt of any firm in order to improve financial performance. This is in line with the findings of this study that revealed a negative significant impact of total debt and long term debt on financial performance of banks in Nigeria.