ABSTRACT
This study was conducted to investigate the effect of financial leverage on financial performance of quoted pharmaceutical companies in Nigeria. The ex-post factor research design was used in measuring the relationship among the variables of the study. Data were collected from secondary source through the annual reports and accounts of six (6) sampled Quoted Pharmaceutical Companies out of a population of eleven quoted Pharmaceutical firms in Nigerian Stock Exchange that have complete financial records either on their website or in the office of the Nigerian Stock Exchange. Multiple regression was used to test the three hypotheses formulated by the study. The results of the descriptive statistics and regression were presented. Result on effect of debt ratio (DR) on Profitability of listed pharmaceutical companies revealed that debt ratio has negative and insignificant impact on the profitability of listed pharmaceutical companies in Nigeria. Result on effects of interest coverage ratio (ICR) on Profitability of listed pharmaceutical companies in Nigeria revealed that interest coverage ratio has no significant effect on Profitability of listed pharmaceutical companies in Nigeria. Finally result on effect of Debt- Equity Ratio (DER) on Profitability of listed pharmaceutical companies in Nigeria also revealed that total debt to total equity has positive significant impact on the performance of listed pharmaceutical companies in Nigeria. In conclusion, the study therefore recommends that managers should work very hard to optimize the capital structure of their firm in order to increase the financial performance. The capital structure of firms should be adequately planned to safeguard the interest of the equity holders, shareholders and financial requirements of the firm.
TABLE
OF CONTENTS
Title Page i
Declaration ii
Certification iii
Dedication iv
Acknowledgement v
Table of Contents vii
Abstract xi
CHAPTER
1: INTRODUCTION
1.1 Background
to the Study 1
1.2 Statement
of the Problem 3
1.3
Objectives of the Study 4
1.4 Research Questions 4
1.5 Statement of
Hypotheses 5
1.6 Significance of the Study 5
1.7 Scope of the Study 6
1.8 Definitions of Terms 6
CHAPTER 2:
REVIEW OF RELATED LITERATURE
2.1 Conceptual Framework 8
2.1.1 Concept of financial leverage 8
2.1.1.1
Measures of financial leverage 11
2.1.1.2
Financial leverage propositions 13
2.1.1.3 Total
debt ratio 15
2.1.1.4 Debt equity ratio 16
2.1.1.5 Long term debt
ratio 16
2.1.1.7 Times interest earned ratio 17
2.1.1.8 Fixed-charge coverage ratio 17
2.1.2 Concept of firm performance 18
2.1.2.1
Measurement of firms’ performance 21
2.1.2.2 Return on assets 22
2.1.2.3 Return on equity 23
2.1.2.4 Earnings per share 23
2.1.2.5 Tobin’s Q 24
2.1.3 Effect of financial leverage 25
2.2 Theoretical
Framework 29
2.2.1 Modigliani
– Miller theorems 30
2.2.3 Dynamic trade-off theory 30
2.2.4 Pecking order theory 32
2.2.5 Agency cost theory 34
2.2.6 Trade-off theory 36
2.3 Review of Empirical Studies 37
2.4 Summary of Empirical
Literature and Establishment of Gap 47
CHAPTER 3: METHODOLOGY
3.1 Research Design 48
3.2 Nature and Sources of Data 48
3.3 Population and Sample Size 48
3.3.1 Sample
Size 49
3.4
Method of data Analysis 50
3.5 Definition and
Measurement of Variables. 50
3.6
Model Specifications 52
3.7 Diagnostic Tests 53
CHAPTER 4: DATA
PRESENTATION AND ANALYSIS
4.0 Introduction 54
4.1 Data
Presentation 54
4.2 Descriptive
Statistics 54
4.3 Analysis
of regression results and discussion of findings 56
4.3.1 Effect of debt
ratio (DR) on profitability of listed pharmaceutical
companies 56
4.3.2 Effects
of interest coverage ratio (ICR) on profitability of
listed pharmaceutical companies in Nigeria 57
4.3.3
Effect
of debt- equity ratio (DER) on profitability of
listed
pharmaceutical
companies in Nigeria. 59
4.3.4 Pooled
effect of financial leverage on financial performance 61
4.4 Test of Hypotheses 62
CHAPTER 5:
SUMMARY OF FINDINGS, CONCLUSIONS AND RECOMMENDATIONS
5.1 Summary
of Findings 65
5.2 Conclusion 66
5.3 Recommendations
67
5.4 Limitations of the Study 68
5.5 Areas for Further Research
69
5.6 Areas for Further Research 70
References 71
Appendices 87
LIST OF TABLES
4.1 Descriptive
statistics variables 54
4.2: Ordinary least squares results on effect of debt ratio (DR) on
profitability 56
4.3: Ordinary least squares results on effect of
interest coverage ratio on profitability 57
4.4 : Ordinary
least squares results on effect of debt- equity ratio (DER) on profitability 59
4.5: Pooled effect 61
CHAPTER 1
INTRODUCTION
1.1 BACKGROUND TO THE STUDY
Financial
leverage can be defined as the amount to which an organization or financier is
using borrowed money; it is a measure of how an organization uses equity and
debt to finance its assets. Many studies have shown that financial leverage has
relationship with financial performance; consequently, employing financial
leverage is like a “double-edged sword” as it has the ability to boost the
firm's potential losses or gains (Khan, 2012; Pandey, 2010).
The
option to use debt and equity combined, comes with costs while relying on debts
only leads to cost savings since debt interest is tax deductible, thereby
reducing on the whole cost of capital (Mueni & Muturi, 2015). Financial
leverage decision is a very important one since the performance of a firm is
directly affected by such decision; therefore, when taking debt-equity mix
decisions, directors/managers should trade with caution.
The
theory of financial leverage and its relationship with organizational'
performance has been an issue in corporate finance and accounting literature in
view of the fact that the influential work of Modigliani and Miller in 1958 (
Al-Taani, 2013; Mohammed, 2010; Ogebe, Ogebe & Alewi, 2013). Modigliani and
Miller (1958) asserted irrelevance of debt-to-equity ratio for firm value.
Financial
performance evaluation is designed to provide answers to a wide variety of
important questions, some of which include whether the company has enough cash
to meet all its obligations, is it generating enough volume of sales to justify
recent investment. Financial leverage is directly linked with financial
performance (Tian & Zeitun, 2007). These measures are interrelated.
Financial
measurement is one of the apparatus which shows the financial strengths,
weaknesses, opportunities and threats. Financial performance evaluation is
regarded as a functional step in attaining a self-evaluation method and as a
result the enhancement of accountability (Mehragan & Golkani, 2012). Some
scholars have considered performance evaluation as a part of the emerging
faction of accountability.
They
believe that one of the best methods of employing accountability is through
performance evaluation. Financial leverage is one of the most noteworthy
decisions made by a firm as it deals with ascertaining the optimum financial
leverage for the firm (Chadha &Sharma, 2015).
Financial
leverage integrates the firm's long term debt, specific short term debt, common
equity and retained earnings, which are all necessary in financing the firm's
general operations and development (Hasan, Ahsan, Rahaman, & Alam, 2014).
Financial leverage mainly merges equity and long term debt but does not in
general consider short term debt (Hasan, Ahsan, Rahaman & Alam, 2014).
Chadha
and Sharma (2015) noted that financial leverage is a continuous financial
leverage can only achieve its optimum point when it boosts the firm's decision
making process that is essential when a firm needs funds for its projects. They
add that market value. They suggest that an optimal financial leverage is one
that maximizes the value of the firm while dropping the cost of capital,
thereby harmonizing the firm's risk and return.
The
challenge is that it is still impossible to determine a definite approach for
determining the firm's optimal financial leverage (Chadha & Sharma, 2015).
Short term debt to total assets is another item in a firm's financial leverage
that affects its financial performance. It affects the financial performance of
a firm either negatively or positively. Furthermore, understanding the
relationship between long-term debt to total assets and performance of various
sectors of an economy is important to all stakeholders. The level of long-term
debt of an organization is also believed to be one of the forces expected to
influence the performance of the organization. Financial Leverages impact on
the value of firms varies across countries due to the dissimilarity in tax laws
and tax brackets (Obradovich & Gill, 2013).
1.2 STATEMENT OF THE PROBLEM
There has been an
ongoing debate on the issue of financial leverage and financial performance of
firms. This controversy is further narrowed down to identify which of the
variables debated is most influential in predicting and determining the
financial leverage of manufacturing
firms. The choice of optimal financial leverage 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 financial leverage. Optimal financial leverage also means that
with a minimum weighted-average cost of capital, the value of a firm is
maximized.
In Nigeria, most
studies did not consider other components on financial leverage 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 financial leverage 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 financial leverage is supposed to cover
both types of debt financing.
Furthermore poor
financial leverage decisions may lead to a possible reduction in the value
derived from strategic assets (Rahul (1997). 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
financial leverage and financial
performance of firms have attracted the attention of many researchers. The studies,
which are largely foreign based, have however revealed conflicting findings,
hence this findings.
Moreover, despite the
widespread interest in the way firms make their financing decisions, most of
the research on financial leverage has been conducted in the advanced
countries’ using different quoted financial companies with little study on
pharmaceutical companies. This study is an attempt to fill this gap in
knowledge; hence, the main purpose of this research is to investigate the effect
of Financial Leverage on Financial Performance: Evidence of Quoted
Pharmaceutical Companies in Nigeria.
1.3 OBJECTIVES OF THE STUDY
The broad objective of this study is to examine the
effect of Financial Leverage on Financial Performance: Evidence of Quoted
Pharmaceutical Companies in Nigeria. Specifically, the study sought to:
i.
determine the effects of Debt
Ratio (DR) on Profitability of listed pharmaceutical companies in
Nigeria.
ii.
evaluate the effects of Interest Coverage Ratio (ICR) on Profitability of listed pharmaceutical companies in
Nigeria; and
iii.
determine the effect of Debt- Equity Ratio
(DER) on Profitability of listed pharmaceutical companies in
Nigeria.
1.4 RESEARCH QUESTIONS
i.
What is the effect of Debt Ratio (DR) on Profitability
of
listed pharmaceutical companies in Nigeria?
ii.
What is the effect of Interest Coverage Ratio
(ICR) on Profitability of
listed pharmaceutical companies in Nigeria?
iii.
What is the effect of Debt- Equity Ratio (DER) on Profitability
of
listed pharmaceutical companies in Nigeria?
1.7 STATEMENT
OF HYPOTHESES
i.
Ho: Debt Ratio (DR) has no significant effect on Profitability of listed pharmaceutical companies in
Nigeria.
ii.
Ho: Interest Coverage Ratio (ICR) has no significant effect on Profitability of listed pharmaceutical companies in
Nigeria.
iii.
Ho: Debt to Equity Ratio (DER) has no significant effect on Profitability of listed pharmaceutical companies in
Nigeria.
1.8 SIGNIFICANCE OF THE STUDY
The
study will be relevant to certain groups of people. They include:
This
study will act as a policy guideline to finance managers involved in managing
firms on the part of financial leverage and its association with return on
equity to maximize shareholder assets. It will aid decision-making relating to
the proper mix between debt and equity that will be of advantage to the firm.
This will in turn establish a proper financial planning that will bring about
improvement in the overall rate of return of the firm since cost of debt
capital is lower than that of equity.
Policy
makers in the industry would be able to formulate appropriate debt and
profitability management policy that would put the company above others in the
same industry because the use of debt increases the earnings on equity capital
as long as the rate of return on the firm’s investment exceeds the explicit
cost of financing the investment.
The
study would add more updated empirical evidence to existing financial
literature in Nigeria regarding relationship between financial leverage and
corporate performance and would be of great benefit to the academic field as it
will serve as a reference point for students and future researchers who will
want to research more on the topic.
1.9 SCOPE OF THE STUDY
Financial
leverage measures the ratio of debt to equity of a firm. This study focuses on
how the financial leverage of quoted pharmaceutical companies in Nigeria
affects the financial performance measured by profitability; The independent
variables of the study are financial leverage proxied by Debt
Ratio (DR); Debt-Equity Ratio (DER) and Interest Coverage Ratio (ICR). The
study was delimited to pharmaceutical companies quoted on the Nigerian Stock
Exchange Floor. To ensure that the objectives of this study are achieved, the
study adopted a sixteen years period (from 2002 to 2017) which is considered
sufficient to establish a relationship among the variables. Data was therefore
extracted from the annual reports of the studied pharmaceutical companies
covering sixteen (16) years from 2002 to 2017.
1.8 OPERATIONAL
DEFINITION OF TERMS
Financial leverage:
Financial
leverage can be defined as the extent to which an Investor or a business is
using borrowed money.
Financial performance:
Financial
performance can be define as the subjective measure of how well a firm can use
assets from its primary mode of business and generate revenues
Debt
This
refers to borrowed funds in the financial leverage
Equity
This
refers to the owners’ capital in the financial leverage
Optimal financial leverage
This
is the level of financial leverage at which the benefits and costs of debt
financing are exactly balanced.
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