The Effects of Capital Structure on Firm’s Profitability: Evidence from Kenya’s Banking Sector

Abstract

Capital structure is considered important corporate financial management context and is mainly related to the establishment of an ideal debt policy. The determination of a company’s capital structure constitutes a difficult decision, one that involves several and antagonistic factors, such as risk and profitability. Despite of substantial theoretical developments in the field of corporate finance over the past several decades, the rift between theory and practice still needs to be reconciled. This paper empirically investigates the relationship between capital structure and the firm’s profitability of banking industry in Kenya, by using panel data extracted from the financial statements of the companies listed on the Nairobi Stock Exchange from year 2004-2012.The rationale behind the industry specific analysis is the fact that exogenous variables appear to force institutions in the same industry in similar fashion, thus leading to the existence of an industry specific capital structure. It is found that a significant positive relationship exists between the short term debt and profitability and statistically significant negative relationship between long term debt and profitability. The results are partially consistent with the previous studies as the negative relationship between long term debt and the firm performance tends to sport the dominant pecking order theory. The association of short term debt and the financial performance in contrast attests the static trade-off theory. Total debt as a whole has no association with the firm’s performance because of the inherited different characteristics of short term debt and long term debt.

Key words: Capital Structure, Profitability, Banking industry, Exogenous variables