Effects of capital structure on financial performance of commercial banks in Kenya

Abstract

The rationale of this study was to provide insights into the relationship between capital structure and financial performance of Kenya’s banking industry. The pioneer work on capital structure by Modigliani and Miller (1958) despite of the unrealistic assumptions has been source of inspirations for scholars. Their propositions state that the market value of any firm and its cost of capital are independent of its capital structure in presence of perfect market conditions. The general objective of t his study was t o assess the effect of capital structure on financial performance of commercial banks in Kenya. The Specific Objectives was t o assess the effect of debt on financial performance of commercial banks in Kenya, t o assess the effect of internal equity on financial performance of commercial banks in Kenya, t o assess the effect of external equity on financial performance of commercial banks in Kenya and t o assess the effect of preference share on financial performance of commercial banks in Kenya. The financial performance was measured using EBIT (earnings before interest and tax). The target population was the banking industry. A census was conducted. Secondary data was used. Data was drawn from a sample of the registered banks by the Central Bank of Kenya in Kenya. According to the central bank of Kenya, there were 43 licensed commercial banks in Kenya. The stud y also used annual reports that were available from their websites and in the Central bank of Kenya website. Data was obtained for a ten year period from 2005 to 2014. Data analysis was done using SPSS software version 21 for efficient data representation. The model equation shows that growth in debt would affect financial performance positively leading to improvement in profitability. If there is an increase in debt levels, the EBIT is expected to increase by 17.6% per unit measure. The study also shows similar effect on retained earnings and preference shares on commercial banks’ financial performance. If there is a unit increase in retained earnings and preference shares, the EBIT will tend to increase by 21.8% and 0.8% respectively, indicating that debt and retained earnings are more significant in predicting financial performance than preference shares which have insignificant factor at 95% confidence level. On the other hand, ordinary shares show different effect, that a unit increase would affect financial performance negatively by decreasing performance at a rate of - 1%.