THE EFFECT OF CAPITAL STRUCTURE ON THE PROFITABILITY OF QUOTED INSURANCE COMPANIES IN NIGERIA

Introduction

1.1 Background of Study

The success of insurance companies in Nigeria business environment depends on the ability of the managers to effectively determine the optimal capital mix which is necessary to ensure that they make profit and shareholders get to see that objective fulfilled which is wealth maximization, capital structure decision is very crucial to any organization; it is very difficult to decide the best combination of debt and equity. Capital structure reflects the firms financing strategy. Therefore the optimal capital structure is said to exist when the debt and equity can be combined to reduce the cost of capital and enhance the firms’ profitability (Mohammed & Khalifa, 2014).

Modigliani and Miller (1958) demonstrated the irrelevance of capital structure in firm value, although the assumption is valuable only in perfect market conditions, where all investors have free access to market information, there are zero transaction costs and no tax difference between dividends and capital gains. However, real economies are far from perfect and thus many financing decisions theories were developed over time in order to demonstrate the purpose of capital mix and its role in company value. (Sorana, 2015)

Capital structure is the way in which a firm finances its operation which can either be through debt or equity or the combination of both (Brigham, 2004). A number of theories explained the relationship between profitability and value of firm. It has been argued that firms with high growth rate have high debt to equity ratio and it has been observed that bankruptcy has an effect on capital structure (Zeituna & Tian, 2007). According to (Kochhar, 1997), poor capital structure may lead to a possible reduction or loss in the value derived from strategic assets. Hence, the capability of a firm in managing its financial policies is important if the firm is to realise gain from it specialised resources (Olokoyo, 2013). The raising of appropriate funds in an organization will aid the firm in its operation. Hence, it is important for firms in Nigeria to know the debt equity mix that gives effective performance after a good analysis of business operation and obligation (Olokoyo, 2013).

The cost of capital is having greater influence on the Earnings before interest and tax level of the firm, which will directly affect the amount of earning available to the investor that finally reflects on the value of the firm. If the manager of an organization decide not to maintain the capital structure of the firm it will affect the firm growth and profitability which will later have financial distress on the profitability of the firm. Firms can also issue dozens of distinct securities in a countless combination to maxima overall market value (Abor, 2005).

Profit has relevance in comparing the efficiency of a business organization. Profitability is the ability of a lucrative activity to generate revenue higher than expenses involved. The profitability measures are known as profitability ratios or accumulated margin (Stefeap, 2008). Profitability means ability to make profit from all business activities of an organization. Profitability is the ability of a given investment to earn a return from its use (Tulsian, 2014). (Erasmus, 2008) noted that financial performance measure like profitability and liquidity among others provide available tools to shareholders to evaluate past financial performance and current position of a company. Profitability is a primary goal of all business a business that does not make profit cannot survive. The ratios used to measure profitability are Return on Capital Employed (ROCE), Return on investment (ROI), Earnings per share (EPS), Gross Profit Margin, Net profit Margin.

Financial performance refers to the degree to which to which financial objectives being or has been achieved. It is the process of measuring the results of firm’s policies and operations in monetary term. Firm performance reflects how effectively companies manage their resources. There is a multitude of capital structure indicators that influence the firm performance and profitability (Sorana, 2015). Firm performance and capital structure has succeeded in attracting a good deal of public interest because it is a tool for socio-economic development (Ayad and Mustafa 2015). Erasmus (2008) noted that financial performance measure like profitability and liquidity among others provide available tools to shareholders to evaluate past financial performance and current position of a company. Financial performance plays a large role in measuring the success of business firms. Evaluating the firm’s performance has three dimensions: the firms’ productivity, profitability,

1.2 Statement of Research Problem

This study is undertaken because it has been observed that a lot of research has been done on effects of capital structure on the profitability of companies like the effect of capital structure on profitability: An empirical Analysis of listed firms in Iraq by (Ayad and Mustafa, 2015), the effect of capital structure on profitability of energy American firms (Mohamed and Tailab, 2014) and Capital Structure and Firms Performance: Evidence from Malaysian listed firms (Salim and Raj, 2012).

There are only a limited number of studies that examine factors that influence the capital structure of Nigerian firms. Although the capital structure issue has received substantial amount of attention in developed countries, it has remained neglected in the developing countries However, little attention has been paid to effect of capital structure on the profitability of quoted insurance companies especially in developing countries like Nigeria.

If there has been any area of finance theory that has attracted the greatest attention and caused the highest controversy, it is definitely theory of capital structure and leverage and how they affect firms’ performance. The choice of capital structure has however being subject to several debates and investigations. The capital structure and firms value has been subject to lots of arguments for many years and it still represented one of the most unresolved issues in corporate finance literature. Only a few people have developed theories that have been tested by empirical studies and theories. Morri and Beretta (2008) explained that numerous theoretical studies and much empirical research have addressed those issues, but there is no generally accepted theory and the debates on the significance of the determinant of factors of capital and profitability is still open.

1.3 Objectives of the Study

The general objective of the study is to examine the impact of capital structure on the profitability of quoted insurance companies in Nigeria.

The specific objectives are:

1. To examine the impact of capital structure on return on asset of quoted insurance companies in Nigeria.
2. To examine the impact of capital structure on return on equity of quoted insurance companies in Nigeria.
3. To examine the impact of capital structure on net profit margin of quoted insurance companies in Nigeria.

1.4 Research Questions

1. Does capital structure has impact on return on asset of quoted insurance companies in Nigeria.
2. Does capital structure has impact on return on equity of quoted insurance companies in Nigeria.
3. Does capital structure has impact on net profit margin of quoted insurance companies in Nigeria.

1.5 Research Hypotheses

H01: Capital structure has no significant impact on return on asset of quoted insurance companies in Nigeria.

H02: Capital structure has no significant impact on return on equity of quoted insurance companies in Nigeria.

H03: Capital structure has no significant impact on net profit margin of quoted insurance companies in Nigeria.

1.6 Operational Models

Objective One: Capital Structure and Return on Asset

ROA= f (CAP)

ROA= f (DR, DER)

ROAit= α0 + α1DEit +α2DERit + µ

Where:

ROA= Return on asset

DR= Debt ratio

DER= Debt-to-equity ratio

i= Cross-section of firm; t=time

Objective Two: Capital Structure and Return on Equity

ROE= f (CAP)

ROE= f (DR, DER)

ROEit= α0 + α1DEit +α2DERit + µ

Where:

ROE= Return on equity

DR= Debt ratio

DER= Debt-to-equity ratio

i= Cross-section of firm; t=time

Objective Three: Capital Structure and Net profit margin

NPM= f (CAP)

NPM= f (DR, DER)

NPMit= α0 + α1DEit +α2DERit + µ

Where:

NPM= Net profit margin

DR= Debt ratio

DER= Debt-to-equity ratio

i= Cross-section of firm (i= 1, 2…., 5); t=time (1, 2… 6)

1.6 Scope of the study

This study is concerned with the effect of capital structure on the profitability of quoted insurance companies in Nigeria; the evaluation of the profitability of insurance firms is for a period of six years 2011-2016.

1.7 Significance of the Study

Acquiring knowledge on the effect of capital structure on the profitability financial of quoted insurance companies in Nigeria will help finance manager to predict potential problems associated with financing decisions and also help to achieve the goals of shareholders

This study have a significant role to play in filling the gap and understanding the effect of capital structure decision on the profitabilit of quoted insurance companies in Nigeria. It will also help financial managers to decide and understand the effect that firm’s capital structure has on profitability in order to maintain and optimal and ideal capital structure.

It will also help investor who wants to in insurance companies to understand and analyze the effect of capital structure on their profitability and maximizing their objectives. It will also serve as a reference for other researchers in the area of financial management.

1.8 Organisation of Study

This research work is organized into five chapters.

Chapter One:

This present the introduction, the statement of problem, objective of study, research questions, hypothesis, scope of study, significant of study.

Chapter Two:

This chapter reviews the conceptual framework, theoretical framework, empirical literatures on capital structure and profitability.

Chapter Three:

This present the research methodology used

Chapter Four:

Data analysis

Chapter Five:

This chapter contains findings, recommendation and summary.

1.9 Operational Definition of Terms

Capital Structure:

This is how a firm finances its overall operations and growth by using different sources of funds. It is a way a company finances its asset through a combination of equity, debt etc.

Optimal Capital Structure:

This indicates the best debt to equity ratio for a firm that maximises its value. It is the one which proffers a balance between the debt to equity ranges thus minimizing the

Long Term Debts:

This consists of loans and financial obligations lasting over one year.

Short Term Debts:

This is made up of any debt incurred by a company that is due within one year.

Equity:

A stock or any other security representing an ownership interest. This is one’s degree of ownership after all debts associated with the asset has been paid off.

Leverage:

This is the investment strategy of using borrowed money, specifically the use of various financial instruments or borrowed capital to increase the potential return of an investment. It is the amount of debt used to finance assets.

Risk:

This is the chance that an investment’s actual return will differ from the expected return, it is the possibility of losing some or all of an original investment.

Financial Risk:

This is the possibility that shareholders will lose money when they invest in a company that has debt, if the company’s cash flow proves inadequate to meet its financial obligation.

Business Risk:

This is the possibility that a company will have lower than anticipated profits or experience a loss rather than taking a profit.