FINANCIAL LEVERAGE AND FINANCIAL PERFORMANCE OF THE ENERGY AND PETROLEUM SECTOR COMPANIES

FINANCIAL LEVERAGE AND FINANCIAL PERFORMANCE OF THE ENERGY AND PETROLEUM SECTOR COMPANIES

ABSTRACT

The main objective of a firm is maximization of shareholders wealth. In attempt to achieve this objective the shareholders appoint management board to oversee the firm’s operations. This study was anchored on the following research objectives; to establish the effect of debt ratio, debt -equity ratio and interest coverage ratio on financial performance of energy and petroleum sector companies listed in the Nigeria Securities Exchange. The study utilized secondary data that was mainly collected from the published financial statements of these companies. Explanatory research design was used. Quantitative secondary data was collected and analyzed using statistical package for the social sciences. This data was also represented using measures of central tendency such as mean, frequencies, percentages and measures of dispersion such as standard deviation. The study ran a multiple regression equation to determine the relationship between the variables in the study and to estimate the models for the study. Descriptive statistics was used to analyze data. In order to draw a conclusion and make recommendations, the analyzed data was further presented in tables, charts and graphs. On the effect of debt ratio on return on assets the study indicated that as the debt ratio increased the return on assets decreased. On the effect of debt equity ratio on return on return on assets the study indicated that as debt equity ratio increased the return on assets decreased. In summary the results indicated that there is a negative relationship between financial leverage and financial performance of petroleum and energy sector firms listed in the Nigeria Securities Exchange.

CHAPTER ONE

INTRODUCTION

1.1       Background of Study

Firms use either debt/ financial leverage or owners’ capital to finance a firm. Financial leverage refers to application of debt financing and borrowed capital in an attempt to increase firm’s operations and profitability. Financial leverage is majorly measured through expressing long term liabilities to equity of a firm. A firm is considered leveraged when the firm is partially financed by both debt and equity. Most firms survive with a significant liquidity level which is mainly achievable through use of debt. Many companies use debt to leverage their profits and capital. This means companies are likely to use debt/leverage to increase assets which in turn increase production and profits.

Debt bears a fixed cost. This means that when a firm increases debt level, the financial leverage level increases. Leverage is the use of borrowed funds for investment purposes (Gatsi, Gadzo & Akoto, 2013). When firm’s management increases the firms profit by using debt element it is an indication of quality corporate governance (Singapurwoko & El-Wahid, 2011). Firm’s investments can be finance by use of either debt or equity. When a firm uses fixed-charged funds especially preference capital and debt along with the shareholder’s equity this is referred to as financial leverage or gearing (Moses and Steve, 2010). When a company’s capital structure is made of only shareholders / owners’ equity only it’s said to be unlevered firm whereas when a firm’s capital structure is made of both debt and owners’ equity it is said to be levered (Olweny and Mamba, 2011). Financial leverage can be informed of a loan or inform of debt (other borrowing). Financial leverage proceeds are reinvested to earn a greater return more than interest expense and cost incurred due to debt acquisition. (Chengand Tzeng, 2010). This means that if a company’s marginal rate of return on asset is higher than the company’s marginal rate of interest expense payable on the debt, then the company should increase the debt level since it will also increase return on equity. Contrary, when the company’s return on asset is lower than the interest rate payable on debt/loan acquisition, the firm should not borrow since borrowing will reduce the firms return on equity, (Athanasoglou, Brissimis and Delis, 2006).

Leverage gives room for increased returns to the investor if available, however it can lead to greater potential loss especially when the investment becomes worthless and the borrowed amount have to be paid with the interest, Andy et al., 2002). This leads to potential financial risk that may lead to financial loss, (Pandey; 2008). The degree of this potential financial risk is associated to the company’s capital structure.

A firm’s financial structure in most instances consist of preferred stock, common equity and the long term and short-term liabilities. This means that the means and ways in which a company finances its assets then constitutes to the company’s financial structure. Consequently, if the company’s short-term liabilities are excluded from the company’s financial structure we obtain the company’s capital structure. In other words, the company’s long-term liabilities consisting of preferred stock, common equity, and long-term debt/loan is referred as capital structure (Banice Olive, 2012). Therefore, the main objective of financial management in a company is structuring the company’s capital structure components in a manner that ensure maximization of shareholders wealth as the key measure of management’s performance. This study will therefore analyze the effects of financial leverage on financial performance which is an indicator of shareholders wealth maximization, Molyneuxandm Thorton, 1992).

Financial leverage is the company’s ability to utilize fixed financial charges to increase the earnings before interest and tax of a company’s earnings per share. In the event that a company does not utilize fixed cost bearing securities, earnings before interest and tax will change and consequently lead to change in earnings per share. If a firm has no fixed financial charges especially preference dividend and interest it’s an indication of financial leverage (Pandey, 2019). Financial leverage gives a firm the ability to magnify its earnings before interest rate and tax thus increasing earnings per share (Saleem, Rahman & Sultana, 2014).

Financial performance refers to firm’s ability to achieve its financial goals and objectives (Yahaya & Lamidi, 2015). Kajirwa (2015) deduced that a firm’s financial performance is depended on firm’s assets utilization in carrying out its income generating business activities.  Financial performance can also be explained as the firm’s general wellbeing, that is, the availability and generation of more finances by a firm over a certain period of time. Financial analyst mostly uses financial performance as a measure to gauge and compare performance of different firms either in the same industry or different industries. This is a key tool in making sound investment decisions. Financial performance is, in summary, is a crucial objective that firms especially the profit-oriented firms desire or aim at to achieve (Yahaya & Lamidi, 2015). Financial performance is a key measure of the performance of any firm. Firm’s ability to make and increase profits depends on the business activities and business capacity. Business capacity is the competence of the financial management to source finances when required from the cheapest source/right source to finance firm’s assets. Business activity refers to the company’s efficiency in utilization of assets to increase production capacity. (Vijayalakshmi & Manoharan, 2014).When a firm is making great profits it is able to tolerate high debt levels since it has higher ability to meet financial obligations arising from debt acquisition.This means that the profit earning firms are more likely to add more debt in the capital structure as compared to firms making losses, this shows that financial performance is key in making financial leverage decisions. Financial performance is measured in terms of return on equity expressed as a ratio of earnings before interest and taxes to total equity.

1.2       Statement of the problem

It is indicated by Dittmar (2004) argued that debt level in a firm determines the amounts of fixed costs paid by the firm. This fixed cost associated with the debt/borrowed finances is referred to as cost of debt which is generally called interest amount. Padron and Santana (2005) asserts that companies that borrow so much from their creditors incur high cost of debt hence lowering the profits/net income. This supports research findings by SooCheong and Eunju (2005) who concluded that their financial leverage/debt affect company’s financial performance and income levels.

Nigeria’s listed firms mainly consider four key elements of debt financing, these elements are: tax considerations, business risk, shareholders risk, and the need for financial flexibility. Listed firms adopt more debt so that they can enjoy less income tax. However; the firm is more exposed to financial risks, Nduati (2010). Debt is worthwhile and helpful if a company will increase its profits levels and increase return on equity/shareholders upon acquisition of debt, Kale (2014). He further explains that most local firms utilize debt for their future plans because fixed cost of debt is usually predetermined, and this enables the firm to plan since the cost is apparent.

Mahira (2011) did a study on the effect of firm financial performance and its financial leverage on capital structure in the automobile sector companies in Pakistan. The study found out that financial leverage and firm’s financial performance have no significant effect on the firm’s capital structure. Akhtar (2012) did a study the impact of leverage on corporate financial performance applied on oil and energy companies’ sector. The study showed that financial leverage leads to improved performance. Maltona (2012) carried out a study to examine and determine the relationship between financial leverage on return on assets. The study involved firms in the three economics sectors of Kuwait. In conclusion the study found out that a positive relationship exists between financial leverage and return on assets.  Nduati (2010) investigated on the relationship between leverage and financial performance of listed firms. It was found that there was a positive correlation between leverage and financial performance. Kale (2014) examined the impact of financial leverage on firm performance: the case of non-financial firms in Nigeria. The findings showed existence of a significant relationship between leverage and return on assets in non-financial firms in Nigeria.

The above studies show that little has been done in relation to financial leverage and financial performance of energy and petroleum sector companies listed firms in the Nigeria Securities Exchange. Further, the studies did not factor in liquidity which is important in establishing whether firms that utilize financial leverage are able to meet their financial obligations. This study therefore attempted to establish the relationship between financial leverage and financial performance of the energy and petroleum sector companies in the Nigeria Securities Exchange.

1.3       Objectives of the study

1.3.1    General Objective

The general objective of the study was to establish the influence of financial leverage on the financial performance of energy and petroleum sector companies listed in the NSE.

1.3.2    Specific Objectives

The study was guided by the following objectives;

• To establish the effect of debt ratio on return on assets of energy and petroleum sector companies listed in the NSE
• To examine the influence of debt-equity ratio on return on assets of energy and petroleum sector companies listed in the NSE
• To examine the influence of interest coverage ratio on return on assets of energy and petroleum sector companies listed in the NSE

1.4       Research Questions

The study sought to answer the following research questions;

• What is the effect of debt ratio on the return on assets of energy and petroleum sector companies listed in the NSE?
• How does debt-equity ratio influence return on assets of energy and petroleum sector companies listed in the NSE?
• How does interest coverage ratio influence return on assets of energy and petroleum sector companies listed in the NSE?

1.5       Significance of the Study

This study is helpful to listed firms as it shows the impact of cost of financing and financial leverage to profitability and financial performance. The research findings will be useful in guiding firms listed in the NSE especially in maintaining a balance between debt and equity, that is, it will guide listed companies in areas of financial management and financial decision making. This study will help firms understand the importance of maintaining optimal capital structure that maximizes market value and shareholders wealth of companies listed in NSE

The study will also help companies in other sectors of the economy to learn how to utilize financial leverage and how its impacts on profitability. The findings of this study might be used as a reference point to firms seeking to finance their projects using financial leverage. The study also adds to the existing body of knowledge on the significance use of financial leverage to the firm and how this contributes to financial performance of the firm. Future researchers and academicians interested in this area of study or other related topics will use the findings of this study as a reference point. In addition, this study can be used as a basis for further research.

1.6       Scope of the Study

The study was carried out on all the energy and petroleum companies listed with the NSE. The population consisted of the energy and petroleum companies listed with the NSE. Secondary data was obtained from published financial statement of these companies. The study sought to determine the role of financial leverage on the financial performance of energy and petroleum listed companies in NSE.

1.7       Limitations of the Study

Creative accounting greatly affects the quality of financial accounting information. Creative accounting is where management of a firm misrepresents facts about the financial position of a company with an aim of showing that the firm is in a better financial position. This limitation was handled by using audited published financial statements sourced from Capital Markets Authority. Audited financial statements provide more reliable and accurate information.

1.8       Organization of the Study

The study comprises of three chapters: chapter one, chapter two and chapter three. Chapter one comprises of the following subsections: background of study, statement of the problem, objectives of the study both the general objective and specific objectives, research questions, significance of the study, scope of the study and limitations of the study.

Chapter two comprises of theoretical review, empirical review, and summary of literature review, research gaps and conceptual framework. Theoretical review discusses theories that the study is anchored on. Empirical review discusses previous studies done concerning financial leverage and financial performance. Chapter four entails the data analysis, presentation and interpretation while chapter five comprises of summary of findings, conclusions and recommendations.

Chapter three discusses the research methodology that will be used to carry out the study. The chapter comprises of the following: the research design, the target population, the sampling procedures and design, data collection instruments and data collection procedures, data analysis and presentation and ethical consideration