CHAPTER ONE

INTRODUCTION

1.1      BACKGROUND TO THE STUDY

Investors, government and other external users of financial information often need to measure the performance of an organization. The performance measurement is done in order to evaluate the success of the business, determine any weaknesses of the business, compare the current and past performance and compare the current performance with industry standard. A company can be recognized as performing effectively and efficiently if it can satisfy the interest of all its stakeholders. For instance managers are interested in their welfare and profit maximization, current and potential shareholders perceive performance as the company’s ability to distribute dividends to their investment, commercial partners look for the solvency and stability of the company while the state seek a company to be efficient in paying its tax and help in creating new jobs. The ability of companies to carry out their stakeholders’ needs is tightly related to capital structure (San and Heng 2011). The capital structure is playing a most important role in the firm’s financial decision making process along with other resources and the term is used to represent the proportionate relationship between debt and equity. Equity is made up of paid-up share premium, share capital, reserve and surplus (retained earnings) (Pandey, 2010). Firms financing decisions involve a wide range of policy issues which such decisions affect capital structure, corporate governance and company development (Green, et al., 2002). Knowledge about capital structures has mostly been derived from data from developed economies that have many institutional similarities (Booth et al., 2011). A firm’s financial performance is measured by how well off the firm is at the end of a period than it was at the beginning. While there are several ways to measure financial performance, the use of financial ratios has gained general acceptance. Financial ratios give an indication of whether the firm is achieving its objectives or not. The ratios can be used to compare a firm’s ratios with other firms or to find trends of performance over time. A firm financial performance depends to a large extent on its financing decisions. Its basic resource is the stream of cash flows produced by its assets. When the firm is financed entirely by common stock, all the cash flows belong to the stockholders. When it issues both debt and equity securities, it undertakes to split up the cash flows into two streams, a relatively safe stream that goes to the debt-holders and a more risky one that goes to the stockholders. The substance of financing decisions cannot be over-emphasized since many of the factors that contribute to business failure can be addressed by a mix of financing decisions that drive growth and the achievement of firm objectives (Salazar, Soto and Mosqueda, 2012). The finance factor is the main cause of financial distress in a number of cases (Memba and Nyanumba, 2013). The financing decisions result in a given capital structure and suboptimal financing decisions can lead to corporate failure. This is a great dilemma for management and investors alike are whether there exists an optimal capital structure. The objective of all financing decisions is wealth maximization and the immediate way of measuring the quality of any financing decision is to examine the effect of such a decision on the firm’s performance. Capital structure is the most significant discipline of firm’s operations (Pratheepkanth, 2011). The option between debt and equity financing is designed to search for best possible mix. Several studies show that a firm with high leverage tends to have an optimal capital structure and therefore leads to produce good financial performance (Lindbergh, 2015; Pratheepkanth, 2011; Iavorskyi, 2013; Nirajini and Priya, 2013; Mujahid and Akhtar, 2014; Javed, Younas and Imran, 2014). However, Modigliani and Miller (1958, 2011), Soumadi and Hayajneh (2012), Simonovska, Gjosevski and Campos (2012), Siro (2013) and Mwangi, Makau and Kosimbei (2014) argue that it has no effect on the value of the firm. These arguments have motivated scholars to examine further the relationship between capital structure and firm’s financial performance. The financing or capital structure decision is a significant managerial decision, as it influences the shareholder return and risk. The market of the share is also affected by the capital structure decision. A firm has to plan its capital structure right from the beginning. Also, in the future if additional fund is to be raised, a capital structure decision is involved. A demand for raising funds generates a new capital structure which needs a critical analysis. Capital structure is the mix of a firm's long-term debt, specific short-term debt, common equity and preferred equity. The capital structure measures how a firm finances its overall operations and growth by using different sources of funds available to it. Debt comes in the form of bond issues or long-term notes payable, while equity is classified as ordinary share, preferred share, reserves or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure. A firm's proportion of short and long-term debt is considered when analyzing capital structure. When people refer to capital structure they are most likely referring to a firm's debt-to-equity ratio, which provides insight into how risky a firm is. Usually a firm more heavily financed by debt poses greater risk, as this firm is relatively highly levered. In Nigeria, there were very few studies undertaken in this specific area with the recent changes. Therefore, this study is carried out to evaluate that the extent to which capital structure of listed manufacturing firms has an impact on their financial performance.

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 manufacturing firms. 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 (2013), 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 choice of capital structure is fundamentally a marketing problem. In the case of Nigeria, the capital structure decision is crucial, as the decision becomes even more difficult, in times when the economic environment in which the company operates presents a high degree of instability (like the case of Nigeria). The firm can issue dozens of distinct securities in countless combination, but it attempts to find the particular combination that maximizes its overall market value [Brealey et al, 2011]. The capital structure to be adopted by a business or organization is a critical decision for the management to make, the decisions are both critical and crucial because of the need to maximize returns to various organizational constituencies and the impact such decision has on an organization’s ability to deal with its competitive environment. It is left to a company to decide to finance its investment either by debt and/or equity. This critical financial decision will have an effect on the debt/equity ratio (debt-equity mix) of the firm. The implication of this debt-equity mix is evident in, but not limited to the shareholders’ earnings, cost of capital and the market value of the firm which is affected by the risk involved. 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 manufacturing firms in Nigeria? This study attempts to provide answers to this fundamental question. The main problem of this research is to study how the capital structure negatively or positively influences on financial performance of manufacturing firms in Nigeria.

1.3      RESEARCH QUESTIONS

1.  To what extent does total debt to total asset ratio affect financial performance of manufacturing firms in Nigeria?

2.  What is the effect of total debt to total equity ratio on financial performance of manufacturing firms in Nigeria?

3.  What is the impact of short-term debt to total assets ratio on financial performance of manufacturing firms in Nigeria?

4.  How does long-term debt to total assets ratio influence financial performance of listed manufacturing firms in Nigeria?

1.4 RESEARCH OBJECTIVES (OBJECTIVES OF THE STUDY)

The major purpose of this study is to examine capital structure and financial performance of manufacturing firms in Nigeria. Other general objectives of the study are:

1.  To examine the extent to which total debt to total asset ratio affect financial performance of manufacturing firms in Nigeria

2.  To examine the effect of total debt to total equity ratio on financial performance of manufacturing firms in Nigeria

3.  To examine the impact of short-term debt to total assets ratio on financial performance of manufacturing firms in Nigeria

4.  To examine the influence of long-term debt to total assets ratio on financial performance of listed manufacturing firms in Nigeria.

1.4 RESEARCH HYPOTHESES

Hypothesis 1

H0: Short term debt to total assets ratio does not have significant impact on the financial performance of manufacturing firms in the Nigeria.

H1: Short term debt to total assets ratio do have significant impact on the financial performance of manufacturing firms in the Nigeria

Hypothesis 2

H0: Long term debt to total assets ratio does not have significant impact on financial performance of manufacturing firms in the Nigeria.

H1: Long term debt to total assets ratio do have significant impact on financial performance of manufacturing firms in the Nigeria

Hypothesis 3

H0: Total debt does not have significant impact on financial performance of manufacturing firms in the Nigeria.

H1: Total debts do have significant impact on financial performance of manufacturing firms in the Nigeria

1.6 SIGNIFICANCE/JUSTIFICATION OF THE STUDY

The findings 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 manufacturing firms 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 manufacturing sector 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 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 Manufacturing firms, 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 manufacturing firms 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.

1.7SCOPE OF THE STUDY 

The study is based on capital structure and financial performance in manufacturing firms in Nigeria.

1.8 DEFINITION OF TERMS (OPERATIONAL)

Management: - This is defined as the process of directing, co-ordination and influencing the operations of an organization so as to obtain desired result and enhance a total performance.

Money:- This can be defined as anything which passes freely from hand to hand and is generally acceptable in settlement of debt.

Hedging: According to (Ebhalaghe, 2010) defined hedging as a system employed to smoothen out unpredictable fluctuations in financial variables so as to aid planning and avoid embarrassment induced by cash shortfalls.

Capital Structure: Capital structure is a combination of debt and equity that corporate firms used to finance their business operations and growth activities.

Profitability: Profitability is seen as proxy of financial performance, which is one of the main objectives of company’s management.