The Effect of Capital Structure on the Performance of Quoted Insurance Companies in Nigeria
OBJECTIVES OF THE STUDY
The main objective of this study is to examine the effect of capital structure on the performance of quoted Nigerian insurance companies. Specifically, it seeks to:
- Determine the impact of leverage on the return on equity of quoted insurance companies in Nigeria.
- Find out the effect of leverage on the return on assets of quoted insurance companies in Nigeria.
- Evaluate the contribution of leverage to return on investment of quoted insurance companies in Nigeria.
AN OVERVIEW OF THE NIGERIAN ECONOMY AND FINANCE INDUSTRY
The finance industry in any economy is reputed to be the engine of growth and the ultimate pillar for sustainable growth and development. The success of any
economy is usually measured by its productive strength and its ability to compete favourably with other economies (Borodo,2010). When the insurance base of a country is strong, such an economy is better equipped to create wealth, thus boosting its Gross National Product and a weak finance industry spells doom for any country (Ekwere,2010).
However, the state of the finance industry in Nigeria has been a worrisome issue for two decades and different policies by past and present political dispensation has been structured to alleviate the funding problems of the industry Adebiyi, 2004 and Olorunisola, 2001 enumerates several development policies taking by the government stated thus: investment company of Nigeria (ICON) in 1959, Nigerian Industrial Development Bank (NIDB) established in January 1964, The Nigerian Bank for Commerce and Industry (NBCI) was established in 1973, National Economic Reconstruction Fund (NERFUND) through promulgation of Decree No 2 of 9 January 1991, The Small & Medium Enterprise Equity Investment Scheme (SMEEIS), The Bank of Industry (BoI) established in 2001. All the above policies were to support different types of businesses with primary aim of developing the medium and large-scale insurance enterprises.
The finance industry in any economy is seen as the catalyst for the transformation of the economy to a dynamic, sustained and diverse economy, as evident from the experiences of developed countries such as United State of America, United Kingdom and some emerging nations like China, Japan, India and possibly few others whose finance industry have played a critical role in the structural transformation of the economy from a subsistence, low production and low income state to one that is dynamic, sustained and diverse economy (Borodo,2010).
Nigeria’s laudable medium term strategy document (National Economic and Empowerment Strategy – NEEDS I) affirmed that the finance industry has enormous potentials for employment generation, wealth creation as well as poverty alleviation. These indicators are very significant in measuring the performance of the finance industry. Thus, a critical review of these indicators showed that the Nigerian finance industry is in a state of comatose as its capability to generate employment, create wealth, reduce poverty and contribute to GDP has been declining over the years (Borodo,2010).
For instance, employment generation and wealth creation by the sector over the past few years has declined sharply from 2,841,083 employees in 2002 to 1,026,305 employees in 2008. Wealth can only be created when the prospective investors find the business environment conducive and profitable to do business. In Nigeria, the operating environment is very harsh with un-conducive policy for borrowing, erratic power supply to insecurity of lives and property as is presently seen in the Niger Delta and the Northern part of the country.
The poverty level in Nigeria has been on the increase in recent times due to deteriorating quality of work life especially in the area of reduction of job opportunities, high costs of living, poor infrastructure and bad living conditions. According to UNDP report on Nigeria in 2007, the level of poverty increased from 46% in 1992 to 70.9% in 2006. Insurance contribution to GDP after independence that was 8.1% in 1970 fell to 4.13% in 2008. For capacity utilization, the state of the finance industry can be appreciated by a scrutiny of the capacity utilization that has been on the decline from 70% in 1975 to 48% in 2008 among other failure.
According to Ajayi (2010) the failure in other sectors of Nigeria’s economy has been likened to Dutch disease since the advent of oil syndrome which shifted attention from other sectors of the economy to oil sector. Dutch disease originated in The Netherlands during the 1960s when the high revenue generated by its natural gas discovery led to a decline in the competitiveness of its other non-booming tradable sectors. Despite the revenue windfall the new discovery brought, The Netherlands experienced a drastic decline in economic growth. It is not surprising to find a private company like the United Nigerian Textiles PLC (UNTL) collapsed; neither is the textile industry, the only distressed sector in Nigeria. Only a few firms are still active. The closure of the United Nigerian Textiles PLC (UNTL), one of the Nigeria’s leading textile firms, again opened another unpleasant chapter in the Nigeria’s economic history.
CONCEPT OF CAPITAL STRUCTURE
A firm’s capital structure refers to the mix of its financial liabilities. As financial capital is an uncertain but critical resource for all firms, suppliers of finance are able to exert control over firms. There are two different ways of financing the assets of an organization; through internal equity or external debt. Capital structure refers to the way a corporation finances its assets through some combination of equity and debt (Tsai et al,2010). However, there are several kinds of equity and debt according to Mc Menamin, (1999) and Ross; et al,(2005). These are common stock, preferred stock and retained earnings (untaxed reserves) as well as bank loans, bonds, accounts payable and
line of credit. Capital structure according to Song (2005) refers to the mix of different types of securities (long-term debt, common stock) which are issued by a company to finance its assets. Chou (2007) sees capital structure as a mixture of debt and equity financing of a firm. Capital structure according to Wikipedia (2010), refers to the way a corporation finances itself through some combination of equity, debt or hybrid securities. From all the definitions above, it is eminent that capital structure in summary refers to the structure of a firm’s liability. Hence, the capital structure theory is highly relevant to the firm’s safety and growth, as well as the debt-holders’ safeguard for a sustainable economy. How to plan financing decision using a particular means or mix of funding to maintain a proper capital structure is an important issue of concern demanding urgent for financing managers if their sectors is ever to play a major role in economic development.
Leverage is defined as the sensitivity of the value of equity ownership with respect to changes in the underlying value of the firm. Empirically, leverage ratios are frequently independent variables (sometimes as part of a hypothesis, sometimes as a control). Leverage ratios are also the dependent variable in the empirical capital structure literature. This literature tries to explain variations in corporate leverage, both in the cross section of capital structure (i.e. why some firms have high leverage) and in the time series (how capital structures evolve). Capital structure refers to the firm’s financial framework which consists of the debt and equity used to finance the firm.
The nature of problem and objective of any study usually determine the type of research design to be adopted by a researcher. Though, various types of research design exist which includes experimental design, historical design, survey design, case study design, ex-post design, correlation design among others. This study utilized the correlation design as it attempts to correlate the effect of leverage on the performance of quoted Insurance companies in Nigeria using the three widely used proxies (i.e Return on Equity, Return on Assets, and Return on Investment) for measuring firm performance. It thus, attempts to establish the underlying facts about their relationship with capital structure.
SOURCES AND METHOD OF DATA COLLECTION
There are basically two sources of data collection i.e both primary and secondary sources of data collection. For the purpose of this study, only secondary method of data collection was utilized i.e textbooks, annual reports, Journals, other published materials, Nigerian Stock Exchange fact books and the annual financial statements of the sampled firms for the periods 2000 to 2009 bearing the flow of financial activities in the sector before the economic meltdown.
POPULATION AND SAMPLING TECHNIQUE
The population of this study consists of all Nigerian insurance companies that enjoy first-tier listing on the Nigerian Stock Exchange (NSE). As at December 28, 2009, a total of one hundred and eight insurance companies enjoy first tier listing on the Nigerian Stock Exchange. However, these one hundred and eight (108) firms form our population.
There are many types of sampling methods. These include among others random sampling, stratified sampling, systematic sampling, multi-stage sampling, cluster sampling and quota sampling. For the purpose of this study, stratified sampling technique is used considering the sectorial grouping of firms in the stock market. A stratified sampling method extends the ideas of simple random sample to ensure that a heterogeneous population has its defined strata taken account of in the sample. One advantage of this method is that the sample itself is free from bias. The selection of strata is subjective and it increases cost due to the extra time and labour necessary for the organization and implementation of the sample.
Slovin’s sampling technique formula is used in determining sample size of this study as adopted by Ariola et al (2006).
Slovin’s formula is written as: n = N / (1 + Ne^2)
Where n = Number of samples
N = Total population e = Error tolerance
Hence: n = 108
1 + 108 (0.15)2
N = 31
To select sample size from each strata from the population size, we now determine our sample size through the use of proportional sampling techniques. As at the time of conducting this study, there were 108 quoted insurance companies.
Finally, our eventual sample size of this study will be 28 insurance companies as against the 31 obtained earlier on. It is pertinent to state that all computation was done on approximate to the nearest whole number. 28 out of 108 insurance companies were selected as our sample representative. This was done using random sampling techniques.
DATA PRESENTATION AND ANALYSIS
Table 4.1 Aggregate Values of Dependent and Independent Variables
SUMMARY, CONCLUSIONS AND RECOMMENDATIONS
This study investigates the effect of Leverage on the performance of Nigerian quoted insurance companies. The problem of the study therefore emanated from at least two reasons: First, Leverage has become a global issue of business financing decision and Nigerian quoted insurance companies are not in exception.
Second, studies have been carried out on the effect of Leverage on insurance companies and small and medium scale enterprises outside Nigeria and to the best of our knowledge non in Nigerian context. This motivated us to find out what will be the position in the Nigerian quoted insurance companies.
In view of the above, the study hypothesized a significant relationship between Leverage and three performance indicators of Nigerian quoted insurance companies namely; return on equity, return on assets and return on investment.
The findings of the research are based on the result of the tested hypotheses. It is also based on the pooled cross-section of time series data collected for the period 2000 to 2009 from 28 samples of quoted insurance companies out of 108. Simple linear regression is used for testing hypotheses. The result of the study reveals that Leverage has a significant effect on the performance of quoted insurance companies in Nigeria.
In accordance with the research finding that Leverage explain the variables of quoted insurance firm’s performance, the study concludes as follows.
Firstly, both empirical and statistical evidence on the effect of Leverage on the three performance indicators namely return on equity, return on assets and return on investment in the Nigerian quoted insurance companies have significant effect on the quoted insurance companies’ performance.
Secondly, the study also concludes that Nigerian quoted insurance companies have performed remarkably well within the period of the study 2000-2009. This may be because of the technological advancements globally.
Finally, the study represents a pioneering attempt in assessing the effect of Leverage on the performance of Nigerian quoted insurance companies looking at performance from the perspective of return on equity, return on assets and return on investment.
In line with the findings of this study, which reveal that Leverage has significant effect on the performance of Nigerian quoted insurance companies and the conclusions drawn by the study, the following recommendations are offered:
- The management of Nigerian quoted insurance companies should work very hard to optimize the capital structure of their quoted insurance companies in order toincrease the returns on equity, assets and investment. They can do that through ensuring that their capital structure isoptimal.
- 2 The Management of Nigerian quoted insurance companies should increase their commitments into capital structure in order to improve earnings from their business transaction.
- The Management of Nigerian quoted insurance companies must caution against the apparent benefits of greater leverage simply as a device for controlling managerial opportunistic behavior. First, debt and equity represent different constituencies with their own competing, and often mutually exclusive, goals. Second, as the level of debt increases, the capital structure can change from one of internal control to one of external
- Investors and stakeholders of quoted Insurance companies in Nigeria should also consider the leverage level of any firm before committing their hard earned money as the strength of a firm financing mix determine the quantum of their returns.
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