IMPACT OF FINANCIAL LEVERAGE ON FIRM PERFORMANCE: EVALUATION OF TOTAL NIGERIA PLC

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1 IMPACT OF FINANCIAL LEVERAGE ON FIRM PERFORMANCE: EVALUATION OF TOTAL NIGERIA PLC Abstract ABDUL, Azeez Department of Accountancy, Federal Polytechnic, Ede & ADELABU, Isiaka Tunji Department of Accountancy, Federal Polytechnic, Ede Debt is used by many companies to leverage their capital and profit. Empirically, the issue has received considerable attention, but the evidence is mixed. Against this backdrop this study presents an empirical insight into the relationship between financial leverage and return on equity and of a company in the oil and gas industry in Nigeria for the period Secondary data obtained from the factbook and annual reports of the purposively selected company were analysed with the use of ordinary least square regression. The results showed that there is positive and significant relationship between financial leverage and financial performance of the company. As leverage increases by one unit, profitability also increases by units. The 46.6% of the variations in the profitability are accounted for by leverage. The study therefore concluded that the company should take more debt to boost profitability. Key words: Financial leverage, Return on equity, Pecking order theory, Trade-off theory INTRODUCTION Leverage refers to the extent to which firms make use of their money borrowings (debts financing) to increase profitability and is measured by long term liabilities to equity. A company is described as leveraged if it is financed partly by debt and partly by equity. A firm cannot survive without significant liquidity position which is feasible with the use of debt. Debt is used by many companies to leverage their capital and profit. However, to increase the assets to generate more profits, companies might use leverage. One type of leverage that the company may use is debt. Debt carries a fixed cost which means that if a company increases its debt, the degree of financial leverage will also increase. Leverage is basically explained as the use of borrowed fund to make an investment and return on that investment. (Gatsi, Gadzo & Akoto, 2013). The ability of the company s management to increase their profit by using debt indicates the quality of the management s corporate governance. Good corporate governance shows the companies performance on their use of debt to increase their profits (Singapurwoko & El-Wahid, 2011). According to Banerjee (2009:165) there should be a proper mix between debt and equity to take advantage of a proper financial planning because debt capital is cheaper than equity capital with the attendant effect of lowering the average cost of capital of the firm. Again, it does not disturb the voting position of the existing shareholders. In addition, there is a degree of flexibility associated with debt-financing and this may bring about an improvement in the overall rate of return of the firm. The use of debt capital 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. 68

2 Financial leverage is the firm s ability to use of fixed financial charges to magnify the effects of changes in the earnings before interest and tax on the firm s earnings per share. In other words, it results when a fluctuation in earnings before interest and tax is accompanied by a disproportionate fluctuation in the firm s earnings per share. If a firm does not use fixed cost bearing securities, a change in earnings before interest and tax will be accompanied by a similar change in earnings per share. So if there are no fixed financial charges (interest and preference dividend) then, there is financial leverage (Pandey, 2010). Apart from altering the cash flow and financial position of a company financial leverage affects return on assets, return on investment and return on equity. It is the ability of a business to use fixed financial charges to magnify the effects of changes in earnings before interest and tax on the earning per share and profits. Financial leverage is employed by every company that that is intended to earn more return on the fixed-charge funds than their costs (Saleem, Rahman & Sultana, 2014). Yoon and Jang (2005) observed that highly profitable firms have lower levels of leverage than less profitable firms because they first use their earnings before seeking outside capital. In addition, stock prices reflect how the firm performs. Firms tend to issue equity rather than debt when their sock price increases so that their leverage level stays lower than firms using leverage. The principal focus of most organizations is profit maximization while the need for optimal finance mix is sacrosanct so as to obviate insolvency. Financial leverage is a measure of how much firms use equity and debt to finance its assets. A company can finance its investments either by debt, equity or preferred stock. The primary motive of a company in using financial leverage is to magnify the shareholders return under favourable economic conditions. The rate of interest on debt is fixed irrespective of the company s rate of return on assets. As debt increases, financial leverage increases. Financial leverage affects profit after tax (Pandey, 2010). Profitability is an essential indicator to measure the performance of a firm. The ability to make profits depends on the capacity and activity of the business. Capacity refers to the competence of the management to procure funds from right source at right time to finance the assets whereas activity measures the efficiency of the company in the utilisation of the assets in enhancing its earning capacity (Vijayalakshmi & Manoharan, 2014). In general, the profitable companies are more able to tolerate high level of debt by virtue of their ability to meet the financial obligations on time. The profit earning can easily add more debt in their capital structure; hence, the profitability plays an essential role in leverage decision. Profitability is taken as the return on equity which is measured as earnings before interest and taxes divided by total equity. As it is suggested by pecking-order theory that highly profitable companies tend to reduce their external funding which eventually sends signals to the lenders that they have low bankruptcy risk (Sheikh & Wang, 2011). In other cases, profitable firms can issue debt at low rates of interest since they are seen as less risky by the lenders. Furthermore, profitable firms are able to generate large earnings with the use of a lesser amount of debt capital than firms that make little profit (Alkhatib, 2012). Al-Najjar and Taylor (2008) argued that profitable companies are inclined to decrease information asymmetry to lenders, investors and interested users through the use of profitability. A good number of factors affect the companies profitability which include size, Explaining the role of leverage in companies financial performance is one of the primary objectives of contemporary studies and this role remains a questionable subject which has continued to attract the attention of many researchers. Despite the numerous studies that have been documented, relationship between financial leverage and profitability remains an unresolved issue in corporate finance. Several theories have been proposed to explain the relationship but there has not been a universal agreement. Researchers like Al-Najjar and Taylor 69

3 (2008); (Sheikh & Wang, 2011); (Alkhatib, 2012); (Saleem, Rahman & Sultana, 2014) and a host of others continue to record different findings about the relationship between leverage and profitability. This study therefore comes to fill the existing gap in literature whether financial leverage has effect on corporate performance of companies in the oil and gas industry. In order to gain an insight into the relationship between financial leverage and corporate performance, the following research question need be answered: What association or the extent of association that exists between financial leverage and corporate performance in terms of profitability. Based on this, the following research hypothesis is formulated: Ho: Financial leverage does not have any relationship with profitability. The main objective of this study is to investigate the effect of financial leverage on the performance of companies in the oil and gas industry and specifically to analyse the relationship between financial leverage and returns on net assets of Total Nigeria Plc. However, this study differs from the previous studies whose concentration had been on banking and manufacturing industries in the sense that its focus is on companies in the oil and gas industry that requires external funding for growth and expansion than companies in other sectors of the Nigerian economy. The results of this study have a number of important practical implications for financial managers, policy makers in the industry as well as the academia. The financial managers need the information provided by this study in deciding on the proper mix between debt and equity to be able to take advantage of a proper financial planning aimed at boosting profitability the effect of which will bring about an improvement in the overall rate of return of the firm because debt capital is cheaper than equity. In addition, the 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. In the final analysis, the study would add more updated empirical evidence to existing financial literature in Nigeria regarding relationship between financial leverage and corporate performance. The rest of this paper is organised as follows: Section two provides the review of literature, section three deals with the methodology used in sourcing and analysing the data for the study. Section four is devoted to results and discussion while section five concludes the study. LITERATURE REVIEW The proportionate mix of equity and debt in financing a firm s investment proposals has been the subject of intensive theoretical modeling and empirical examination over the years having its tenet in the implication of such a mix on corporate performance (Akinmulegun, 2012). There are many empirical works on the relationship between leverage and corporate performance. However, the findings are mixed. Some studies found positive relationships between financial leverage and corporate performance while others identified negative relationships. A study by Wabwile, Chitiavi, Ondiek, Alala and Douglas (2014) on financial leverage and performance variance among first tier commercial banks listed on Nairobi Security Exchange Kenya during 2007 to 2011 revealed negative correlation between debt asset ratio and return on capital employed. Saleem, Rahman and Sultana (2014) examined the impact of leverage on profitability of oil and gas sector of SAARC countries using analysis of variance and t-test. It was found out that financial leverage positively and greatly affects return on assets, return on investment and return on equity. Akinmulegun (2012) also reported that financial leverage significantly affects corporate performance likewise Vijayalakshmi and Manoharan (2014) shared the same view. Akhtar and Oliver (2009) investigated the relationship between financial leverage and corporate performance and found out that a positive relationship exists between the financial leverage and the performance of the energy companies in Pakistan. Likewise a study by Al-Shamaileh and Khanfar (2014) 70

4 found the existence of a statistically significant impact for the independent variables (financial leverage and ROI) of the Tourism companies on the Profitability. In contrast to the above views Yoon and Jang (2005) examined the effect of financial leverage on profitability of Restaurant firms and discovered that financial leverage does not influence the restaurant firms profitability. Alcock, Baum, Colley and Steiner (2013) analyzed the role of financial leverage in the performance of private equity real estate funds using 169 real estate private firms and reported a negative relationship between leverage and profitability. equity real estate funds over the period 2001 to Singapurwoko and El-Wahid (2011) analysed the impact of financial leverage on profitability of non-financial companies listed on Indonesia Stock Exchange and reported a negative and insignificant relationship between financial leverage and profitability. According to Yoon and Jang (2005), profitability which is the most significant determinant of firms financial leverage negatively affects debt to asset ratios in the heteroskedastic tobit regression model. Sheel (1994) also supported the negative relationship between debt-to- asset ratio and non-debt tax shield and between firm s leverage behaviour and its past profitability. Similarly, Akinlo and Asaolu (2012) observed in their studies that leverage has negative effect on profitability of Nigerian firms during 1999 to Fengju, Fard, Maher and Akhteghan (2013) also investigated the relationship between financial leverage and profitability with emphasis on income smoothing in Iran s capital market and discovered that there is no correlation between financial leverage and profitability. Likewise Awan (2014) examined the impact of liquidity, leverage, inflation on firm profitability in the food sector of Pakistan and found out that debt ratios are negatively associative with return on assets and return on sales. However, this study is linked to pecking-order theory and static trade-off theory. The pecking order theory states that financial oriented companies would not opt for debt financing for their new projects because of the availability of sizeable amounts of internal funds (Abu, 2007). Unlike static trade-off theory, which emphasises that financially sound companies would give preference to the use of debt financing in view of the attraction of tax shield benefit available on borrowed funds. The static trade off theory predicts a direct relationship between profitability and leverage while the pecking order theory expects an inverse-relationship between them (Jong, Verbeek & Verwijmeren, 2011). The static trade-off theory postulates that larger size companies have a higher preference for debt financing because of a lower probability of bankruptcy due to their tendency for diversification (Gats, Gadzo and Akoto (2013). However, Yoon and Jang (2005) explained that the most profitable firms in many industries often have the lowest debt ratio, which is very different from the predictions of the trade-off theory of capital structure. METHODOLOGY In order to analyse the impact of financial leverage on the performance of companies in the oil and gas industry, secondary data obtained from the factbook and annual reports and accounts of Total Nigeria Plc were used. Total Nigeria Plc was purposively chosen as a sample for the study because apart from being listed on the Nigerian Stock Exchange it appears to be one of the leading oil companies in Nigeria. The study covered a period of ten years ( ). Profitability, defined as return on net assets (dependent variable) was measured using profit after tax to net assets while financial leverage (independent variable) was measured with long-term debt to equity where equity is defined as share capital plus reserves. Data were analyzed using SPSS software version 20 through Pearson correlation coefficient. RESULTS AND DISCUSSIONS Based on the analysis of data, the findings and the results are hereby presented and discussed. 71

5 The regression result in table 1 below is in consonance with the expectation that the independent variable (log of leverage ratio) will have positive impact on profitability ratio. The regression model developed has a constant of with a small error of attributable to the predictor (leverage ratio). This implies that the profitability will be (0.53%) when the regression (log of leverage ratio) takes on zero value. The coefficient of the log of leverage ratio is The p value is showing significant relationship. This implies that there is positive relationship between (log of leverage ratio and log of profitability ratio) from 2004 to As leverage increases by one unit, profitability increases by units. The significant t-value of for leverage indicates that the profitability in comparison to other unconsidered variables held constant plays a vital role in explaining profitability for Total Nigeria Plc. The linearity of regression model with regard to significance level and t is accepted. Table 1: Pearson Correlation coefficient of the relationship between leverage and profitability Model Unstandardized Coefficients Standardized Coefficients t Sig. B Std. Error Beta 1 (Constant) Leverage Source: Survey 2015 An examination of the model summary in conjunction with (t value) showed that the coefficient of determination of (R 2 ) is given as (0.526). This implies that the total variance in the dependent variable caused by the predictor (leverage) is (0.526) or (52.6%). The adjusted coefficient of determination (adjusted R 2 ) is given as (0.466). This means that precisely (46.6%) of the variations in the profitability are accounted for by leverage, after the co-efficient of determination has been adjusted to make it insensitive to the number of included variables. Table 2: Model Summary b Model R R Square Adjusted R Square Std. Error of the Estimate a a. Predictors: (Constant), Leverage b. Dependent Variable: Profitability CONCLUSION Durbin- Watson This study examined the relationship between leverage and profitability of Total Nigeria Plc between 2004 and The results suggested that a linear relationship exists between leverage and profitability. As leverage increases by one unit, profitability increases by units. This is an indication that, changes in the leverage position of the company exert a remarkable change in the profitability. Other factors such as firm s growth, capital and advertisement intensity, age of firm, business cycle trends, and technological changes among others may also exert a greater influence on the profitability of the company. Based on the findings, the null hypothesis is rejected at significance level of 5%. Conceptually, this result is consistent with the study of Al-Shamaileh and Khanfar (2014). 72

6 In conclusion, the company should increase their debt ratio to boost their profit level but the implication of this is that since the supplier of debt has limited participation in the company s profit and therefore will insist on protection in earnings and protection in values represented by ownership equity. Essentially, selection of debt as a source of capital finance should be in line with the costs and benefits associated with the use of debt. Therefore, the study recommends that the company should continue to increase its level of gearing to enjoy large profit levels. However, this study suffers from certain limitations: It is purely based on one company in the oil and gas industry, data representing a period of ten years were used; thus making the results to be indicative and not conclusive, hence the need for further research. REFERENCES Abu Jalal M. (2007). The Pecking Order, Information Asymmetry, and Financial Market Efficiency. University of Minnesota. USA: Akinlo, O. & Asaolu, T. (2012). Profitability and leverage: Evidence from Nigerian firms. Journal of Business Research, 6 (1): Global Akinmulegun, S.O. (2012). The effect of financial leverage on corporate performance of some selected companies in Nigeria. Canadian Social Science, 8(1): Akhtar, S., & Oliver, B. (2009). Determinants of Capital Structure for Japanese Multinational Corporations. International Review of Finance, 9: and Domestic Alcock, J., Baum, A., Colley, N. & Steiner, E. (2013). The role of financial leverage in the performance of private equity real estate funds. Journal of Portfolio Management Special Real Estate Issue: Alkhatib, K. (2012). The determinants of leverage of listed companies. International Journal of and Social Science. 3(24): Business Al-Najjar, B., Taylor, P. (2008). The relationship between capital structure and ownership evidence from Jordanian panel data. Journal of Managerial Finance, 34 (12), structure: new Al-Shamaileh, M.O. & Khanfar, S.M. (2014). The Effect of the Financial Leverage on the Profitability in the Tourism Companies (Analytical Study-Tourism Sector-Jordan). Business and Economic Research, 4(2): Awan, M.R. (2014). Impact of liquidity, leverage, inflation on firm profitability an empirical analysis of food sector of Pakistan. IOSR Journal of Business and Management, 16(1): Banerjee, B. (2009). Fundamentals of Financial Management. New Delhi: PHI Learning Private Limited. Fengju, X., Fard, R.Y. Maher, L.G. & Akhteghan, N. (2013). The relationship between financial leverage and profitability with an emphasis on income smoothing in Iran s capital market. European Online Journal of Natural and Social Sciences, 2(3s):

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