THE EFFECT OF LEVERAGEONFINANCIAL PERFORMANCE

OFMICROFINANCE INSTITUTIONS IN NAKURU COUNTY

WINNIE RIAKO NYAMEYO

D61/66988/2011

A RESEARCH PROJECT SUBMITTED IN PARTIAL

FULFILLMENT OF THE REQUIREMENTS FOR THE AWARD
OF THE DEGREE OF MASTER OF BUSINESS
ADMINISTRATION SCHOOL OF BUSINESS, UNIVERSITY OF
NAIROBI

OCTOBER, 2014
 DECLARATION

I declare that this project is my original work and has not been submitted for

examination in any other university.

Signed ………………………………… Date………………………………

Winnie Riako Nyameyo

D61/66988/2011

This project has been submitted for examination with my approval as the university

supervisor

Signed ………………………………… Date………………………………

Mr. Mirie Mwangi

Lecturer

Department of Finance and Accounting

School of Business, University of Nairobi

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 ACKNOWLEDGEMENTS

I would like to thank my supervisor Mr.Mirie Mwangi forhis guidance, insightful

criticism, valuedadvice, flexibility and availability during the writing of this project.

I am honoured to have worked with you on this project and may God bless you.

iii
 DEDICATION

This project is dedicated to my family; my father Dr. George Nyameyo and my

mother Anne Nyameyo, who both instilled in us the value and importance of

education in our lives and to always strive to achieve the best in our endeavours. My

siblings Beryl, Rachael Svetlana and Lyton who in one way or the other gave me the

zeal and zest to soar to greater heights. May you achieve more than this.

Finally to my partner and husband Jeff for giving the invaluable support, pushing me

to achieve more and always being by my side.

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 TABLE OF CONTENTS

DECLARATION ..................................................................................................... ii
ACKNOWLEDGEMENTS .................................................................................... iii
DEDICATION ........................................................................................................ iv
LIST OF TABLES ................................................................................................. vii
LIST OF ABBREVIATIONS ............................................................................... viii
ABSTRACT ............................................................................................................ ix

CHAPTER ONE:INTRODUCTION ...................................................................... 1

1.1 Background of Study ........................................................................................... 1
1.1.1 Leverage ............................................................................................... 2
1.1.2 Financial Performance of Microfinance Institutions ............................... 4
1.1.3 The Relationship between Leverage and Financial Performance of
Microfinance Institutions ............................................................................... 5
1.1.4 Microfinance Institutions in Nakuru County .......................................... 6
1.2 Research Problem ................................................................................................ 7
1.3 Objective of the study .......................................................................................... 9
1.4 Value of the Study ............................................................................................... 9

CHAPTER TWO:LITERATURE REVIEW ....................................................... 11

2.1 Introduction ....................................................................................................... 11
2.2 Theoretical Framework ...................................................................................... 11
2.2.1 Portfolio Theory .................................................................................. 11
2.2.2 Theory of Finance (Financial Intermediation) ...................................... 12
2.2.3 Trade off Theory ................................................................................. 13
2.3 Determinants of Financial Performance ............................................................. 15
2.3.1 Technological Innovations ................................................................... 15
2.3.2 Size of the Firm ................................................................................... 16
2.3.3 Risk Profile of the Firm ....................................................................... 16
2.3.4 Liquidity of the Firm ........................................................................... 16
2.3.5 Leverage of the Firm ........................................................................... 16
2.4 Empirical Studies ............................................................................................... 17
2.5 Summary of Literature Review .......................................................................... 23

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CHAPTER THREE ............................................................................................... 24
RESEARCH METHODOLOGY .......................................................................... 24
3.1Intoduction ......................................................................................................... 24
3.2 Research Design ................................................................................................ 24
3.3 Population ......................................................................................................... 24
3.4 Data Collection .................................................................................................. 24
3.5 Data Analysis .................................................................................................... 25
3.5.1 Analytical Model................................................................................. 25
3.5.2 Tests of Significance ........................................................................... 26

CHAPTER FOUR ................................................................................................. 27

DATA ANALYSIS, RESULTS AND DISCUSSIONS ......................................... 27
4.1 Introduction ....................................................................................................... 27
4.2 Response Rate ................................................................................................... 27
4.3 Descriptive Statistics .......................................................................................... 27
4.4 Correlation Analysis .......................................................................................... 28
4.5 Regression Analysis and Hypotheses Testing ..................................................... 29
4.5.1 Model Summary .................................................................................. 29
4.5.2 Analysis of Variance ........................................................................... 30
4.5.3 Tests of Coefficients ............................................................................ 30
4.6 Discussion of Research Findings ........................................................................ 32

CHAPTER FIVE ................................................................................................... 34

SUMMARY OF FINDINGS, CONCLUSIONS AND DISCUSSIONS ............... 34
5.1 Introduction ....................................................................................................... 34
5.2 Summary of Findings and Discussions ............................................................... 34
5.3 Conclusions ....................................................................................................... 35
5.4 Policy Recommendations ................................................................................... 37
5.5 Limitations of the Study..................................................................................... 38
5.6 Suggestions for Further Research ....................................................................... 39

REFERENCES ...................................................................................................... 41
APPENDIX: LIST OF MFI’s IN NAKURU COUNTY ....................................... 46
APPENDIX II:SECONDARY DATA ................................................................... 47

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 LIST OF TABLES

Table 4.1: Descriptive Statistics ............................................................................... 27

Table 4.2: Correlation of the Study Variables .......................................................... 28
Table 4.3: Model Summary ..................................................................................... 29
Table 4.4: ANOVA ................................................................................................. 30
Table 4.5: Tests of Coefficients ............................................................................... 31

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 LIST OF ABBREVIATIONS

ANOVA Analysis of Variance

CBK Central Bank of Kenya

GMM Generalized Method of Moments

MFIS Microfinance Institutions

ROA Return on Assets

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 ABSTRACT

The aim of this study was an attempt to determine the effect of financial leverage on
financial performance of microfinance institutions in Nakuru County. The sample
data was extracted from financial statements of seven licensed micro finance
institutions in Kenya as at 31 st June 2013. Census was used in getting the information.
The study used secondary data since the nature of the data to be collected was
quantitative in nature. The study used secondary data sources of a five year period
from 2009-2013 based on the accessibility and availability of data. Data collected was
sorted, cleaned and coded and then entered into Statistical Package for Social science
for analysis. A multiple regression model was used to show the relationship between
the independent and the dependent variables. The model explains the relationship
between four variables namely: debt to equity ratio, portfolio to assets ratio and
operating expense ratio (Independent variables) with financial performance (the
dependent variable). The Pearson’s r for the correlation between the Debts divided
Equity ratio and ROA variables is 0.884. This means that there was a strong positive
relationship between the two variables. Since the Sig (2-Tailed) value is less than 0
.05. It was concluded that there is a statistically significant correlation between the
two variables at the 0.01 level. This means that there is a strong relationship between
the two variables. According to the regression analysis, the findings revealed that
66.3% is explained by the variables under the study meaning that the model is a good
predictor. Central banks of Kenya should encourage commercial banks to use
leverage in managing risks. This is because the relationship between operating
leverage and financial leverage is multiplicative rather than additive. Operating
leverage and financial leverage can be combined in a number of different ways to
obtain a desirable degree of total leverage and level of total firm risk. Future
researchers may extend study period and may also take all the deposit taking Sacco
that are regulated by SASRA. Researcher can also conduct comparative study by
taking data from deposit taking Sacco’s and Non deposit taking Sacco to check the
relationship between financial leverage and financial performance. The study was
limited to one county:Nakuru County and therefore the findings and recommendations
made on this study cannot be used to make generalization of other microfinance
institutions operating in the 47 counties in Kenya. It is therefore important for future
researchers to test the same variables on all the microfinance institutions in all the
counties then findings and conclusions can be made based on concrete facts and
evidence.

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 CHAPTER ONE

INTRODUCTION

1.1 Background of Study

In the current business environment financial managers have adopted various capital

structures as a means to that goal. A firm can finance its investment by debt and

equity. The use of fixed-charged funds, such as debt and preference capital along with

the owner’s equity in the capital structure is described as financial leverage or gearing

(Dare and Sola, 2010). An unlevered firm is an all-equity firm, whereas a levered firm

is made up of ownership equity and debt (Olweny and Mamba, 2011).

Financial leverage takes the form of a loan or other borrowing (debt), the proceeds of

which are (re)invested with the intent to earn a greater rate of return than the cost of

interest (Chengand Tzeng, 2010).If the firm’s marginal rate of return on asset (ROA)

is higher than the rate of interest payable on the loan, then its overall return on equity

(ROE) will be higher than if it did not borrow. On the other hand, if the firm’s return

on assets (ROA) is lower than the interest rate, then its return on equity (ROE) will be

lower than if it did not borrow (Athanasoglou, Brissimis and Delis, 2006). Leverage

allows a greater potential returns to the investor than otherwise would have been

available, but the potential loss is also greater: if the investment becomes worthless,

the loan principal and all accrued interest on the loan still need to be repaid (Andy et

al., 2002).

This constitutes financial risk (Pandey; 2008). The degree of this financial risk is

related to the firm’s financial structure. The total combination of common equity,

preferred stock and short and long term liabilities is referred to as financial structure.

That is, the manner in which the firm finances its assets constitutes its financial

1
structure. If short-term liabilities are subtracted from the firm’s financial structure, we

obtain its capital structure. In other words, the firm’s permanent or long-term

financing consisting of common equity, preferred stock and long term debt is called

capital structure (Van Horne, 2002). Hence, the objective of financial management in

structuring a firm’s capital components is to maximize the shareholders wealth, as a

measure of performance. Based on the above, the problem of this study is to analyze

the implications of financial leverage on performance. Also considering that

maximizing accounting profit and maximizing shareholders value are not identical

because of shareholders losses from agency costs, it is therefore pertinent to see how

capital structure affect shareholders value (Molyneuxandm Thorton, 1992).

1.1.1 Leverage

Leverage, sometimes referred to as gearing is a general term for any technique to

multiply gains and losses. Leverage is the use of fixed costs in a company’s cost

structure (Dare and Sola, 2010). Operating leveragerelates to the company’s operating

cost structure and financial leveragerelates to the company’s capital structure. Most

often it involves buying more of an asset by using borrowed funds, with the belief that

the income from the asset will be more than the cost of borrowing. Almost always this

involves the risk that borrowing costs will be larger than the income from the asset

leading to incurred losses.

Theamountinwhichapurchaseispaidforinborrowedmoney.Thegreatertheleverage,thegre

aterthepossiblegainorpotentialloss (Cheng andTzeng, 2010).

Leverage allows a financial institution to increase the potential gains or losses on a

position or investment beyond what would be possible through a direct investment of

it’s own funds. There are three types of leverage; balance sheet, economic, and

2
embedded and no single measure can capture all three dimensions simultaneously.

The first definition is based on balance sheet concepts, the second on market-

dependent future cash flows, and the third on market risk. Balance sheet leverage is

the most visible and widely recognized form (Hart, 2002).

The leverage ratio can thus be thought of as a measure of balance sheet or, to the

extent that it also includes off-balance-sheet exposures economic leverage. A firm can

finance its investment by debt and/or equity. The use of fixed-charged funds, such as

debt and preference capital along with the owner’s equity in the capital structure is

described as financial leverage or gearing (Dare and Sola, 2010). An unlevered firm is

an all-equity firm, whereas a levered firm is made up of ownership equity and debt.

Financial leverage takes the form of a loan or other borrowing (debt), the proceeds of

which are (re)invested with the intent to earn a greater rate of return than the cost of

interest. If the firm’s marginal rate of return on asset (ROA) is higher than the rate of

interest payable on the loan, then its overall return on equity (ROE) will be higher

than if it did not borrow (Molyneux and Thorton, 1992).

Leverage allows a greater potential returns to the investor than otherwise would have

been available, but the potential loss is also greater: if the investment becomes

worthless, the loan principal and all accrued interest on the loan still need to be repaid

This constitutes financial risk .The degree of this financial risk is related to the firm’s

financial structure. The total combination of common equity, preferred stock and

short and long term liabilities is referred to as financial structure. That is, the manner

in which the firm finances its assets constitutes its financial structure. If short-term

liabilities are subtracted from the firm’s financial structure, we obtain its capital

structure (Naceur and Goaied, 2008).

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1.1.2 Financial Performance of Microfinance Institutions

Performance refers to the accomplishment of a given task measured against preset

standards of accuracy, completeness, cost, and speed. In other words, financial

performance refers to the degree to which an achievement is being or has been

accomplished. Most microfinance instructionsapply the recommended measures for

financial analysis that determine a firm’s financial performance through grouping this

measures into five broad categories namely liquidity, solvency, profitability,

repayment capacity and financial efficiency (Bush and Kick, 2009).

Performance refers to how well a company is using its resources to make profits or

create shareholder value. Financial measures are expressed in monetary units. The

techniques used for analytical purposes include; ratios, trends analysis and cross

sectional analysis (Van Horne, 2002). A ratio is a mathematical expression of an

amount in terms of another.Financial performance in financial institutions refers to the

ability to operate efficiently, profitability, survive grow and react to the environmental

opportunities and threats. In agreement with this, performance is measured by how

efficient the enterprise is in use of resources in achieving its objectives (Pandey,

2008).

When determining the financial performance of a firm most microfinanceinstitutions

review past and present financial information since they are not the only factors

affecting a firm’s financial performance rather measuring a group performance is

more important than focusing on only one or two measures at the exclusion of others,

(Crane, 2010). Thefinancial indicators of financial performance applied by most

microfinance instructions include: sales growth, return on investment (ROI), and

return on sales, return on equity (ROE), and earnings per share. The ratios that

4
measure organizational performance can be summarized as profitability and growth:

return on asset (ROA) and return on investment (ROI) (Drago, 1990). Return on

average assets and return on equity are used as financial measures when determining

the level of financial performance of microfinance institutions (Olwenyand Mamba,

2011).

1.1.3 The Relationship between Leverage and Financial Performance

of Microfinance Institutions
Microfinance institutions often use leverage when constructing their capital structure,

which helps lower total financing cost. In addition to the relatively lower cost of debt

financing, using debt has other advantages compared to equity financing, despite

potential issues that using debt may cause, such as ongoing financial liabilities and

potential bankruptcy risk (Bourke,1989).Therefore leverage can magnify both gains

and losses of the microfinance institutions. A firm can utilize its debt to invest in

profitable investments to make profits or create shareholder value this increases the

financial performance of a firm

Use of leverage helps microfinance institutions to improve on their financial

performance since they are able to keep profits within a company and increases

returns on equity for current company owners and helps secure tax savings (Dang

2011).The importance of using leverage to finance assets by microfinance institutions

compared to equity is because debt requires lower financing cost, this positively

impacts on financial performance of firms (Bikkerand Hu, 2002).Most microfinance

institutions often mix debt into their capital structure to bring down the average

financing cost. Using debt, microfinance institutions are contractually liable to make

periodic interest payments and return debt principal at maturity (Molyneuxand

Thorton, 1992).

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As a result, the firms bear less risk, compared to firms that finance their assets using

equity. Upon liquidation of the firm, debt holders have more claiming rights to

company assets; this gives them security for their investments (Boyd and Rankles

1993).Microfinance institutions that finance their projects using leverage might easily

retain profits and financial performance within the firm as compared to using equity,

firms prefer leverage to finance stable business operations in which they can more

easily make ongoing interest payments and retain the rest of the profits to themselves.

Firms that use leverage to finance their assets are likely to pay low taxes due to

allowable interest deductions. Tax rules permit interest payments as expense

deductions against revenues to arrive at taxable income. The lower the taxable

income, the less taxes a company pays. For instance dividends paid to equity holders

are not tax-deductible and must come from after-tax income. Tax savings help further

reduce a company’s debt financing cost, which is an advantage that equity financing

lacks which might significantly lead to financial performance (Lazarus, 1997).

1.1.4Microfinance Institutions in Nakuru County

Microfinance refers to all types of financial intermediation services; savings, credit

funds transfer, insurance, pension remittances, provided to low-income households

and enterprises in both urban and rural areas, including employees in the public and

private sectors and the self-employed (Robinson, 2001).It can be considered at several

levels of institutional, group, and individual and can relate to organizational,

managerial, and financial aspects (Rao, 2001). As of 2007, the Central Bank of

Kenya, CBK reported the existence of 56 micro finance institutions (MFIs) operating

in Kenya. MFIs in Nakuru County are mostly branches or units whose headquarters

are domiciled in the capital, Nairobi Kenya (CBK, 2013). Nakuru County has seven

6
micro finance institutions which are dispersed in major towns where they have

operational footprint.

Most of these MFIs have branches countrywide, enhancing their outreach to deserving

Kenyans, and thus deepening financial inclusion as a way of expansion and growth. In

Kenya, MFIs face challenges between achieving financial performance and

contribution to poverty reduction, this negatively affects their financial

performance.The performance of micro finance institutions can be affected by internal

and external factors.These factors can be classified into specific (internal) and

macroeconomic variables. The internal factors are individual characteristics of the

microfinance institution which affects its financial performance; these factors are

basically influenced by the internal decisions of management and board. The external

factors are sector wide or country wide factors which are beyond the control of the

firm and thus negatively affect the profitability of any financial institution for

example change of technology(Robinson, 2001).

1.2 Research Problem

High leverage may initiate clashes between managers and shareholders due to

selection of investment equity, debt or hybrid. When the leverage is relatively high to

a certain limit, it leads to an increase in debt and it will increase cost of debt,

including an increase in cost of bankruptcy or financial distress due to conflicts

between equity holders and bondholders. To make distinction between these two

sources of agency costs empirically is very difficult (NaceurandGoaied,

2008).Argument of free cash flow predicts that higher leverage might raise financial

performance due to the reason that managers of such firms are lesser able to initiate

with projects showing negative net present value.

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In Kenya, microfinance institutions in Nakuru County may consider to use leverage to

finance their projects. Leverage is a keystone mechanism that can be deployed by

management to maximize shareholder return and boost financial performance of

microfinance institutions.When cash is not available for investing in projects that

create value for the microfinance institutions, firms may apply leverage in order to tap

into opportunities that generate additional returns for the organization. These kinds of

projects should maximize value for shareholders in the long run. The use of leverage

in the capital structure lowers the firms weighted average cost of capital and provides

tax gains for most microfinance institutions in Kenya that lack adequate finances to

finance their projects and purchase assets.

Leverage comes at a price. When leverage increases, studies indicate that the risk

attributable to the firm also increases. Leverage raises the chances of bankruptcy for

the organization. Cash-flows are directed towards the servicing of debts regardless of

whether the company makes a profit or not.Bikerand Hu (2002) in their study

concluded that debt was one of the cheapest sources of financing a firm. It was found

that firms that used debt to finance their assets performed better that those that used

equity.Other researchers; Bourke(1990), investigated on the relationship between

expenses and profitability, the study revealed that the higher the expenses of a

financial institution the lesser the profitability of a financial institution. This negative

relationship between expenses and profitability has been supported by Bourke (1989)

implying that profitable banks are able to operate at lower costs.

Studies have been done in relation to financial performance of microfinance

institutions in Kenya:Njoroge (2008) found that the size of loan to members relative

to total asset was positive and highly significant predictor of performance, confirming

8
the priori premise that loan is the most productive asset of any financial institution.

Other researchers:Adongo (2012) in his study found that there was an insignificant

relationship between returns adjusted by risk and financial leverage on firms listed at

the Nairobi Securities Exchange.Nduati (2010) investigated on the relationship

between leverage and financial performance; it was found that there was a positive

correlation between leverage and financial performance.

The above studies have not addressed or examined the relationship between leverage

and financial performance of microfinance instutions.This study therefore attempts to

answer the following researchquestion: what is the effect of leverage on financial

performance of microfinance institutions in Nakuru County?

1.3 Objective of the study

To determinethe effect of leverage on financial performance of microfinance

institutions in Nakuru County.

1.4 Value of theStudy

The findings of this study will be resourceful to microfinance institutions; it will shed

more light on how a firm can finance its assets and projects using leverage. Firms that

lack sufficient capital to invest in projects might also benefit from the findings of this

study since they can gain more knowledge on the advantages of financing assets by

use of debt.

This study may be useful to the government and other policy makers in setting

policies that encourage financial institutions to issue debts to their customers in order

to grow and expand businesses. Debt is one of the cheapest sources of income if the

processes of issuing loans by financial institutions are well managed.

9
Researchers and academicians interested in this topic or other related topics stand to

benefit from the findings of this study since they can learn on the importance of using

leverage as a source of financing. Researchers can also use this study as a basis for

further research.

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 CHAPTER TWO

LITERATURE REVIEW

2.1 Introduction

The section covers the theories in relation to leverage and financial performance; it

also provides the determinants of financial performance, empirical studies and the

summary of the literature review.

2.2 Theoretical Framework

This section covers theories that show the effect of leverage on financial performance

of firms. These theories are namely: portfolio theory, theory of finance and trade off

theory.

2.2.1 Portfolio Theory

This theory was put forward byMarkowitz (1952);the portfolio theory provides a

normative approach to the investor’s decision to invest in asset or securities under

risk. It is based on the assumption that investors are risk averse. This implies that

investor hold well diversified portfolio instead of investing their entire wealth on

single asset or security (Nawrocki, 1997). Portfolio is a combination of individual

assets or securities. Profit is the ultimate goal of commercial banks. All the strategies

designed and activities performed thereof are meant to realize this grand objective.

However, this does not mean that commercial banks have no other goals.

Microfinance institutions could also have additional social and economic goals

(Myers and Stewart, 1984).

Modern Portfolio Theory is a normative theory that asserts that investors should

choose investments based on discounted future expected returns and that for

11
maximum risk adjusted returns, investors should diversify across industries and asset

classes. The theory is simple, but application requires many variations and

refinements to accommodate circumstances and can be quite difficult to achieve

(Black, Jensenand Scholes, 1972).

Modern portfolio theorists argue that firms should diversify their portfolios in order to

achieve financial performance. It is possible for an investor to always have a fund

available for withdrawals that would be up in the current market, thus avoiding

permanent loss of value due to bad timing (Israelsen, 2001). MPT was further refined

by SharpeandTobin(1988) into the Capital Asset Pricing Model (CAPM).In the

CAPM, mean variance analysis by investors is assumed. The CAPM decomposes the

risk of an investment into two kinds of risk, systematic and specific. In the CAPM,

Sharpe (1988) said that “the market does not reward specific risk, since specific risk

can be offset by diversifying the portfolio”. In contrast to the normative nature of

MPT, the CAPM is a descriptive theory of equilibrium relationships between

expected rates of return and risk (Black, Jensenand Scholes, 1972).

2.2.2 Theory of Finance(Financial Intermediation)

This theory was put forward by Martin, Cox,and MacMinn (1988).The theory of

finance in a modern sense starts with the Modigliani and Miller (1958) capital

structure irrelevance proposition. Before Modigliani and Miller, there was no

generally accepted theory of capital structure. They start by assuming that the firm has

a particular set of expected cash flows. When the firm chooses a certain proportion of

debt and equity to finance its assets, all that it does is to divide up the cash flows

among investors. Investors and firms are assumed to have equal access to financial

markets, which allows for homemade leverage. The investor can create any leverage

12
that was wanted but not offered, or the investor can get rid of any leverage that the

firm took on but was not wanted. As a result, the leverage of the firm has no effect on

the market value of the firm (Mossin, 1973).

As a matter of theory, capital structure irrelevance can be proved under a range of

circumstances. There are two fundamentally different types of capital structure

irrelevance propositions. The classic arbitrage-based irrelevance propositions provide

settings in which arbitrage by investors keeps the value of the firm independent of its

leverage (Stiglitz, 1981). Finance theory stresses cash flow and the expected return on

competing assets. The firm's investment opportunities compete with securities

stockholders can buy. Investors willingly invest, or reinvest, cash in the firm only if it

can do better, risk considered, than the investors can do on their own. Finance theory

thus stresses fundamentals. It should not be deflected by accounting allocations,

except as they affect cash taxes (Miller, 1991).

The proponents of this theory of finance explainhow much profit a company earned

compared to the total amount of shareholder equity invested or found on the balance

sheet. ROE is what the shareholders look for in return for their investment. A business

that has a high return on equity is more likely to be one that is capable of generating

cash internally.

2.2.3 Trade off Theory

This theory was propounded by Modiglianiand Miller (1958); the term trade-off

theory is used by different authors to describe a family of related theories. In all of

these theories, a decision maker running a firm evaluates the various costs and

benefits of alternative leverage plans. Often it is assumed that an interior solution is

obtained so that marginal costs and marginal benefits are balanced (Ball, 1994).The

13
original version of the trade-off theory grew out of the debate over the Modigliani-

Miller theorem. When corporate income tax was added to the original irrelevance

proposition (Modiglianiand Miller, 1958) this created a benefit for debt in that it

served to shield earnings from taxes. Since the firm’s objective function is linear, and

there is no offsetting cost of debt, this implied 100% debt financing (Andrews,

1979).To avoid this extreme prediction, an offsetting cost of debt is needed. The

obvious candidate is bankruptcy (Nawrocki, 1996).

Copeland, Westonand Shastri (2003) provide a classic statement of the theory that

optimal leverage reflects a trade-off between the tax benefits of debt and the

deadweight costs of bankruptcy. According to Cookand Campbell (1979), a firm that

follows the trade-off theory sets a target debt-to-value ratio and then gradually moves

towards the target. The target is determined by balancing debt tax shields against costs

of bankruptcy. Several aspects of Myers’ definition merit discussion (Brealey,

Richard, Stewartand Myers, 2003).

First, the target is not directly observable. It may be imputed from evidence, but that

depends on adding a structure. Different papers add that structure in different ways.

Second, the tax code is much more complex than that assumed by the theory (Cissell,

Cisselland Flaspohler, 1990).Depending on which features of the tax code are

included, different conclusions regarding the target can be reached.

Oviatt (1989) provides a useful review of the literature on tax effects. Bankruptcy

costs must be deadweight costs rather than transfers from one claimant to another.

The nature of these costs is important too. For the adjustment to be gradual rather than

abrupt, the marginal cost of adjusting must increase when the adjustment is larger.

This assumed form of adjustment cost is rather surprising since one expects to see

14
large fixed costs and perhaps roughly constant marginal costs. This implies a very

different adjustment path. Martinand MacMinn (1988) describe the implications of

alternative adjustment cost assumptions. For these reasons, we break Myers’s

dentition into two parts. The first part we call the static trade-off theory. The second

part we call target adjustment behaviour (Markowitz, 1952).

2.3 Determinants of Financial Performance

There various determinants of financial performance that have an effect on the level

of leverage of microfinance institutions namely, technological innovations, size of the

firm, risk profile of the firm, liquidity and leverage of the firm.

2.3.1 Technological Innovations

The factors that have been mentioned in some studies that determine the performance

of MFIs namely return on asset and yield of portfolio. Technology for example

product innovation, plays an important role in enhancing financial performance of the

firm (Olwenyand Mamba, 2011).

Product innovation enables the microfinance institutions to develop products that are

user friendly and this leads to an increase in customer deposits since customers can

easily access financial services conveniently.This leads to an increase in financial

performance of microfinance institutions (Naceur and Goaied, 2008). To achieve

financial performance microfinance institutions should put in place proper credit

management practices to prevent financial losses that might be attributable to defaults

leading to financial loss (Molyneux and Thorton, 1992).

15
2.3.2 Size of the Firm

The other determinant of financial performance is the size of the firm. Large firms are

more likely to manage their working capitals more efficiently than small firms. Most

large firms enjoy economies of scale and thus are able to minimize their costs and

improve on their financial performance (Chengand Tzeng, 2010).

2.3.3 Risk Profile of the Firm

Risk profiles a significant determinant of financial performance. Proper management

of working capital management components helps in reducing the costs of the firm.

This highly contributes in reducing the liquidity risk of the firm and thus mitigating

any financial losses that might be attributed to lack of finances to take advantage of

profitable investments (Dareand Sola, 2010).

2.3.4 Liquidity of the Firm

Liquidity of the firm is a key determinant of the firm’s financial performance

Liquidity risk can be measured by two main methods: liquidity gap and liquidity

ratios. The liquidity gap is the difference between assets and liabilities at both present

and future dates. At any date, a positive gap between assets and liabilities is

equivalent to a deficit. Liquidity ratios are various balance sheet ratios which should

identify main liquidity trends (Dareand Sola, 2010).

2.3.5 Leverage of the Firm

Leverage of the firm is a key determinant of financial performance of the firm. The

firms leverage decisions centres on the allocation between debt and equity on

financing a firm (Staikourasand Wood, 2004).Leverage affects the level and

variability of the firm's after tax earnings and hence, the firm's overall risk and return.

16
The study of leverage is significant due to the following reasons. Operating risk refers

to the risk of the firm not being able to cover its fixed operating costs. Since operating

leverage depends on fixed operating costs, larger fixed operating costs indicates

higher degree of operating leverage and thus, higher operating risk of the firm. High

operating leverage is good when all Empirical studies have been performed to analyze

the relationship between leverage and corporate performance. Gweyi, Minoo and

Luyali (2013) in their paper Determinants of leverage of Savings and Credit Co-

operative Societies in Kenya”. The study sample included 40 Saccos registered by

Sacco Society Regulatory Authority (SASRA).High operating leverage is good when

sales are rising but a risk when the sales are falling (Short, 1979).

2.4 Empirical Studies

Empirical studies have been performed to analyze the relationship between leverage

and corporate performance. Gweyi, Minoo and Luyali (2013) in their paper

“Determinants of leverage of Savings and Credit Co-operative Societies in Kenya”.

The study sample included 40 Saccos registered by Sacco Society Regulatory

Authority (SASRA) extended from the period 2010 to 2012. For the data analysis,

regression model was employed; the explanatory variables comprised of firm size,

growth rate, liquidity profitability and tangibility, whereas the explained variable was

the leverage ratio. The results show that for Saccos; there were statistical significant

relationships. The results from the study revealed that firm size has significant

relationship with leverage at 99% confidence level, whereas liquidity and tangibility

have significant relationship with leverage at 95% confidence level.

Obradovich and Gill (2013) had researched on the impact of corporate governance

and financial leverage on the value of American Firms. For this purpose a sample of

17
333 firms listed on New York Stock Exchange (NYSE) for a period of 3 years from

2009-2011 was selected. The co-relational and non-experimental research design was

used to conduct this study by taking firm value as dependent variable and CEO,

Duality, Board Size, Audit Committee and Financial Leverage as independent

variables. The purpose of this study was to find the impact of corporate governance

and financial leverage on the value of American firms. Overall outcomes show that

larger board size negatively impacts the value of American firms and CEO duality,

audit committee, financial leverage, firm size, return on assets and insider holdings

positively impact the value of American firms.

Andy et al.(2002) had investigated the Effects of Financial Leverage on Future Stock

Value at the Stock Exchange. The research statistical population which consisted of

those fromTehran stock exchange listed active cement industry companies analyzed

from 2005 to 2008. By taking financial leverage and market to book value ratio as

variable and to analyze data and test hypothesis of the present research, descriptive

and inferential analyzing methods and SPSS statistical software were applied. They

concluded that leverage does not affect future stock value of the firm. The results

indicate non-response of capital market against levered nature of the firm. Lack of

relationship between leverage and firm value approves net operational income (NOI)

theory and Miller and Modigliani (M.M) theory.

Akhtar et al. (2012) had investigated the impact of influence on shareholders return.

In their paper “Relationship between Financial leverage and Financial Performance:

Evidence from Fueland Energy Sector of Pakistan, they demonstrated that financial

leverage has got a positive relationship with financial performance”. Hence, the

companies in the fuel and energy sector may enhance their financial performance and

18
can play their role for the growth of the economy while improving at their optimal

capital structures. In their study they employed a sample of 20 listed public limited

companies from Fuel and Energy sector listed at Karachi Stock Exchange (KSE). The

study aimed at measuring the relationship between financial leverage and the financial

performance. To test the hypothesis, the main variables used in the study consist of a

dependent variable which is financial performance of fuel and energy sector while the

independent variable is financial leverage in fuel and energy sector. It was revealed

that there was a statistically positive relationship between financial leverage and

financial performance of firms.

The Effect of Financial Leverage on Corporate Performance of Some Selected

Companies in Nigeria (Ojo (2012), empirically examines the effect of financial

leverage on selected indicators of corporate performance in Nigeria. Leverage

therefore significantly affects corporate performance in Nigeria. Other detailed

objectives are to: Examine the impact of leverage on the earnings per share and net

assets per share of corporate firms in Nigeria. The econometric findings presented in

this study evidence that leverage shocks (debt/ equity ratio) have significant effect on

corporate performance especially when the net assets per share (NAPS) is used as an

indicator of corporate performance in Nigeria over the period covered by the study.

Earnings per share depend on feedback shock and less on leverage shock. Also, the

outcome exposed that the influence of shock on earnings per share indirectly disturb

the net assets per share of firms as the majority of the shocks on the net assets per

share was received from earnings per share of the firms.

Adongo(2012) conducted a study to establish the effect of financial leverage on

profitability and risk of firms listed at the Nairobi Securities Exchange (NSE) for the

19
periods 1 January 2007 to 31 December 2011. A casual research design was adopted

for the study. Population consisted of fifty eight companies out of which thirty

companies were sampled. Sample exclude fifteen companies listed under banks and

insurance because these companies are regulated and are to meet certain liquidity and

leverage ratios. Six companies were suspended. Three companies were newly listed

and therefore not continuously listed over the period of study. Four companies had

information missing for some years required for the computation of the variables.

Secondary data was used and data collected from the thirty companies sampled.

Source data included NSE database, Capital Markets Authority (CMA) and Annual

Audited Financial Statements of sampled companies. Data was analyzed using

Statistical Packages for Social Sciences (SPSS) version 17. Cross-sectional time

series fixed model was used with the regression and correlation analysis to determine

the nature and the strength of the relationship between the independent and dependent

variables. Based on the regression and correlation analysis, the findings of the first

model indicated that 14.2% of variation in profitability was explained by financial

leverage and there existed a negative relationship. This means that for every 1%

change or increase in financial leverage, there is a 14.2% decrease in profitability and

vice versa. The second finding showed that 23.5 % variation in risk was explained by

financial leverage and there existed a positive relationship. Meaning that as financial

leverage increases by 1%, risk increases by 23.5%. The third finding indicated a 3%

variation of returns adjusted by risk being explained by financial leverage and there

existed a negative relationship. As financial risk increases by 1%, returns adjusted by

risk decreases by 3% and vice versa. This indicates an insignificant relationship

between returns adjusted by risk and financial leverage. The findings of the study did

not reveal what was expected.

20
Nduati (2010) carried out a study to establish the relationship between leverage and

performance of listed companies at the Nairobi Stock Exchange with reference to the

period 2003-2007 when the NSE experienced an unprecedented boom. Companies at

the market did take up different forms of debt to maximize returns and the researcher

will seek to find out the extent of relationship between the debt and the resulting

performance. The main sources of literature will be: books, internet sources, journals,

annual financial reports and press reports. A descriptive research design will be

adopted in the collection of data. Data will be collected using interviews and

secondary sources such as annual financial reports of the targeted companies.

Analysis will be done with the use of SPSS and findings presented in the form of pie

charts, graphs and tables.

Njoroge (2008) conducted a study to identify the determinants of financial

performance of Savings and Credit Cooperative (SACCO) societies in Kenya. A

cross-sectional time series data covering the period 2002-2007 was compiled from

audited financial records of the sample societies. Random-effects generalized least

square (GLS) regression was used to relate financial performance to factors

hypothesised to be determinants of performance. The study found that the size of loan

to members relative to total asset was positive and highly significant predictor of

performance, confirming the a priori premise that loan is the most productive asset of

any financial institution. Similarly the proportion of equity capital relative to asset

was positive and significant, indicating that capital structure is important. High

growth in assets and loan to members is related to high financial performance. The

ratio of operating expenses to total asset was negative and highly significant

indicating that better cost management could improve performance.

21
Kawiche (2013) conducted a study on the relationship between selected factors and

performance of Microfinance institutions in Tanzania by integrating financial

performance measures. The study used a descriptive survey. The study used the

following variables: debt ratio, portfolio to assets ratio and operating expense ratio as

key measures of performance. The study was analyzed using a regression model. The

findings of the study show that the financial performance of the MFI’s reviewed was

low. This low financial performance was due to the low profit margin. In addition, the

high amounts of operating expenses and liabilities drained down the amount of net

income of the MFI’s.

Salim (2012) carried out a study on the relationship between size and financial

performance of commercial banks in Kenya. The study adopted the Descriptive

Design. Correlation Analysis, and Multiple and Simple Linear regressions were

applied to secondary data collected from available financial statements of all the 43

commercial banks in existence in Kenya as at 31st December, 2011. The period the

study covered was the year 2000 to the year 2011. The main findings of the study

established strong correlations between all the studied factors of Bank Size. Total

Deposits, Total Loans, Total Assets and Branch Network Size were all found to be

correlated. The relationship between three of the size variables, namely, Total Loans,

Total Deposits, and Total Assets and the Financial Performance of commercial banks

were all found to be weak but statistically significant. Total Deposits and Total Assets

had relatively stronger effects on Financial Performance compared to Total Loans. No

relationship was found between Branch Network Size and Financial Performance for

commercial banks in Kenya.

22
2.5 Summary of Literature Review

The chapter presents theoretical and empirical literature on thethe effect of leverage on

financial performance of microfinance institutions. From the above literature it is

evident that leverage is a cheaper source of capital to finance projects, assets and

other key activities of the firm. Thereare certain advantages that make leverage an

attractive source of capital since it can magnify profits and gains of the firm. A firm

that finances it assets through leverage enjoys taxdeductions. The firm might easily

retain profits and financial performance within the firm as compared to using equity,

firms prefer leverage to finance stable business operations in which they can more

easily make ongoing interest payments and retain the rest of the profits to themselves.

This is supported by Gweyi, Minoo and Luyali (2013) and Andy et al.(2002) who

have revealed that a positive relationship exists between leverage and financial

performance of firms.

23
 CHAPTER THREE

RESEARCH METHODOLOGY

3.1Intoduction

This chapter provides an outline of the research methodology that was used in

achieving the objective of this study. It presents the research design, target population,

data collection, data analysis procedures and the analytical model that was used in

data analysis.

3.2 Research Design

The study used a descriptive survey. A descriptive survey is usually concerned with

describing a population with respect to important variables with the major emphasis

being establishing the relationship between the variables anddetermining the

frequency with which something occurs or the extent to which two variables co-

vary(Kothari, 2004).

3.3 Population

According to Cooper and Schindler (2003) a population refers to an entire group of

individuals, events or objects having a common observable characteristic. The

population of the study comprised of seven licensed micro finance institutions in

Kenya as at 31st June 2013. Census was used in getting the information. A census is

an attempt to collect data from every member of the population being studied rather

than choosing a sample.

3.4 Data Collection

The study used secondary data since the nature of the data to be collected was

quantitative in nature. The secondary data will be got fromCentral Bank of Kenya.

24
McNeilland Chapman (2005) explain that there are many methods of data collection

and the choice of data collection depends on the nature of the data to be collected by the

researcher. The study used secondary data sources of a five year period from 2009-

2013 based on the accessibility and availability of data. This enabled the researcher to

get quantified data that is helpful in drawing conclusions and giving recommendations

on the effect of leverage on financial performance of microfinance institutions in

Nakuru County.

3.5 Data Analysis

Secondary data from the audited financial statements was reviewed for completeness

and consistency for purposes of analysis. McNeilland Chapman (2005) explains data

must be cleaned, coded and properly analyzed in order to obtain a meaningful report.

Data collected was sorted, cleaned and coded and then entered into Statistical Package

for Social science for analysis. A multiple regression model was used to show the

relationship between the independent and the dependent variables as provided below:

3.5.1 Analytical Model

This study sought to extend the model as advanced by Kawiche (2013).Below is the

regression model that was used to determine the effect of leverage on financial

performance of microfinance institutions in Nakuru County. The model explains the

relationship between four variables namely: debt to equity ratio, portfolio to assets

ratio and operating expense ratio (Independent variables) with financial

performance(the dependent variable). The model of this study is explained below:

Y=α+β1X1+β2X2+β3X3 + ε

Where:

25
Y= Financial performance was measured using Return on Assets which is measured

as Net income/ Total assets

X1= Debt to equity ratio, wasmeasured usingtotal liabilities/stakeholders equity

X2= portfolio to assets ratio, will was measured usinggross loan portfolio/total assets

X3=Operating expense ratio, wasmeasured using operating expense/Revenue

β= is a regression constant

α= Constant Term

ε = Error term normally distributed about the mean of zero

3.5.2 Tests of Significance

Whereby Y is the dependant variable financial performance, β0 is the regression

constant or Y , β1….β3 are the coefficients of the regression model. Coefficient of

determinationwas used to test whether the model is a good predictor; correlation was

used to show the relationship between the independent variables and the dependent

variable. The test of significance was analysis of variance test (anova).

26
 CHAPTER FOUR

DATA ANALYSIS, RESULTS AND DISCUSSIONS

4.1Introduction

This chapter presents the results of the data analysis. Secondary data in the form of

published financial reports of microfinance institutions in Kenya was obtained from

the AMFI. This data was then converted to the desired form and entered into SPSS

version 22. Data analysis was then conducted to generate descriptive and correlations

output. These results are as shown in the proceeding sections.

4.2 Response Rate

The study sought to collect data from all the seven (7) Microfinance institutions in

Nakuru County. The researcher managed to collect data from all the

seven(7)Microfinance institutions in Nakuru County in a period of five years between

2009-2013.

4.3 Descriptive Statistics

In order to determine the relationship between leverage and financial performance, the

study used descriptive statistics by use mean, median and the standard deviation.

Below are the results of the findings provided in the table 4.1:

Table 4.1: Descriptive Statistics

Minimum Maximum Median Mean Std.
Deviation
Debt Equity Ratio 2.92 668.05 33.48 56.1817 7.49544

Portfolio to Assets .03 59.47 25.07 29.75 5.4544

Ratio
Operating Expense .52 24.61 12.56 12.43 3.5256
Ratio
Return on Assets .45 18.1 12.07 9.275 3.045

Financial 0.4 12 6 6.5 2.49

Performance
Source:Research Findings

27
In table 4.1 statistical analysis of financial performance indicator is shown. The

maximum value of debt to equity ratio is668.05 while the minimum value is 2.92

while the average for the industry is 56.1817 with a standard deviation of 7. 9495.

The maximum value of portfolio to assets ratio is 59.47 while the average for the

industry is 29.75 with a standard deviation of 54.544. The maximum value of

operating expense ratio is24.61 while the minimum value is.52 while the average for

the industry is 12.43 with a standard deviation of 3.5256.Return on Assets had a

maximum value of 18.1 and the average for the industry is 9.275 with a standard

deviation of 3.045

4.4 Correlation Analysis

Correlation measures the strength between the variables.Below is the correlation

between leverage and financial performance of microfinance institutions in Nakuru

County. The results of the findings are presented in table 4.2.

Table 4.2: Correlation of the Study Variables

Debt to Portfolio to Operating Financial Performance

Equity Ratio assets Ratio Expense
Ratio

Debt to Equity Ratio 1

Portfolio to assets Ratio .926 1

Operating Expense Ratio .764 .561 1

Financial Performance .884 .634 .554 1

Source:Research Findings

Table 4.2 shows the relationship between debt toequity ratio and various financial

performance indicators. The Pearson’s r for the correlation between the Debt/Equity

ratio and ROA variables is 0.884. This means that there is a strong positive

28
relationship between the two variables. Since the Sig (2-Tailed) value is less than 0

.05. We can conclude that there is a statistically significant correlation between the

two variables at the 0.01 level. This means that there is a strong relationship between

the two variables.

4.5 Regression Analysis and Hypotheses Testing

In determining the relationship between the independent and the dependent variable a

multiple regression was conducted. The research study aimed at evaluating the

relationship between financial leverage and financial performance of microfinance

institutions in Nakuru County. Below are the results of the findings:

4.5.1 Model Summary

The researcher used the model of the summary in establishing the coefficient of

determination (R2) and the coefficient correlation (R) between the variables.Below

are the results of the findings in table 4.3

Table 4.3: Model Summary

Model Summary
Std. Error of the
Model R R Square Adjusted R Square Estimate
a
1 .814 .663 .771 0.211
a. Predictors: (Constant),debt to equity ratio, portfolio to assets ratio, operating
expense ratio
Source: Research Findings

The findings revealed that 66.3% is explained by the variables under the study

meaning that the model is a good predictor. R=0.814 is the correlation between the

variables which shows that there is a positive correlation between leverage and

financial performance of microfinance institutions in Nakuru Couny.

29
4.5.2 Analysis of Variance

Analysis of variance shows the relationship between the two variables. This section

shows you the p-value (“sig” for “significance”) of the predictor’s effect on the

criterion variable. P-values less than .05 are generally considered “statistically

significant. In this case the researcher will observe the relationship between liquidity

and financial performance.

Table 4.4: ANOVA

Sum of
Squares Df Mean Square F Sig.
Model
1 Regression 2.107 3 0.7023 21.947. .031(a)

Residual 0.832 26 0.032

Total 3.209 29

Source: Research Findings

From the above findings, it was observed that the probability value is0.031,meaning

that the regression model was stastically significant in predicting the relationship

between financial leverage and financial performance of microfinance institutions in

Nakuruand the predictor variables since this value is less than5%. With the help of the

F-Test table (5%, 3, 26) tabulated value was 2.98 which is smaller than F= 21.947 as

well indicated that the model was significant.

4.5.3 Tests of Coefficients

The study carried out the statistical significance of the overall relationship between

the dependent variable and the independent variables, SPSS provides us with the

statistical tests of whether or not each of the individual regression coefficients are

significantly different from 0, as shown in the table below:

30
Table 4.5: Tests of Coefficients

Standardized
Unstandardized Coefficients Coefficients
Model B Std. Error Beta t Sig.
1 (Constant) 1.157 0.214 .321 0.122 .000
Debt to equity Ratio .347 .215 .116 1.325 .003
Portfolio to assets .221 .116 .127 .124 .021

Operating expense .423 .057 .113 .312 .011

ratio
a. Dependent Variable: ROA

Source: Research Findings

The study used a multiple regression analysis so as to determine the relationship

between leverage (Independent variable) and financial performance (Dependent

variable) of microfinance institutions in Nakuru County. Below are is the regression

model that was obtained:

ROA = 1.157+.347X1+.221X2+.423X3

From the regression model holding all the other factors constant, an increase in one

unit of the independent variables(Debt to equity ratio, portfolio to assets ratio and

operating expense ratio) results into a corresponding increase in the dependent

variable (ROA).This means that there exists a direct relationship between the

dependent and the independent variables. The analysis was undertaken at 5%

significance level. The criteria for comparing whether the predictor variables were

significant in the model was achieved by comparing the corresponding probability

value obtained and α=0.05. If the probability value is less than α, then the predictor

variable is significant. Therefore, from the above analysis financial leverage was

significant in the model as its corresponding predictor variables were less than 5%.

31
4.6 Discussion of Research Findings

From the findingsobtained, the regression equation further implied that there was a

direct relationship between financial leverage and financial performance of

Microfinance Institutions in Nakuru County. The analysis was undertaken at 5%

significance level. Therefore, from the above analysis financial leverage was

significant in the model as its corresponding predictor variables were less than

5%.This shows that the model is a good predictor which is well explained by the

coefficient of determination R2=76.3%.

These findings are consistent with these studies:Akhtar et al. (2012) had investigated

the impact of influence on shareholders return. In their paper “Relationship between

Financial leverage and Financial Performance: Evidence from Fueland Energy Sector

of Pakistan, they demonstrated that financial leverage has got a positive relationship

with financial performance”. Hence, the companies in the fuel and energy sector may

enhance their financial performance and can play their role for the growth of the

economy while improving at their optimal capital structures. In their study they

employed a sample of 20 listed public limited companies from Fuel and Energy sector

listed at Karachi Stock Exchange (KSE).

The study aimed at measuring the relationship between financial leverage and the

financial performance. To test the hypothesis, the main variables used in the study

consist of a dependent variable which is financial performance of fuel and energy

sector while the independent variable is financial leverage in fuel and energy sector. It

was revealed that there was a statistically positive relationship between financial

leverage and financial performance of firms.

32
According to the findings, it was revealed that 66.3% is explained by the variables

under the study meaning that the model is a good predictor. R=0.814 is the correlation

between the variables which shows that there is a positive correlation between

leverage and financial performance of microfinance institutions in Nakuru County.

The unexplained variations by the model is only 33.7% which means that the model is

a good predictor.

The results of the correlation between leverage and financial performance found that

there was a strong positive correlation between leverage and financial performance of

R=0.884. These findings are coherent with a study that was conducted

by: Adongo(2012) on the effect of financial leverage on profitability and risk of firms

listed at the Nairobi Securities Exchange (NSE) for the periods 1 January 2007 to 31

December 2011. Based on the regression and correlation analysis, the findings of the

first model indicated that 14.2% of variation in profitability was explained by

financial leverage and there existed a negative relationship. This means that for every

1% change increase in financial leverage, there is a 14.2% decrease in profitability

and vice versa.

The second finding showed that 23.5 % variation in risk was explained by financial

leverage and there existed a positive relationship. Meaning that as financial leverage

increases by 1%, risk increases by 23.5%. The third finding indicated a 3% variation

of returns adjusted by risk being explained by financial leverage and there existed a

negative relationship. As financial risk increases by 1%, returns adjusted by risk

decreases by 3% and vice versa. This indicates an insignificant relationship between

returns adjusted by risk and financial leverage. The findings of the study did not

reveal what was expected.

33
 CHAPTER FIVE

SUMMARY OF FINDINGS, CONCLUSIONS AND

DISCUSSIONS

5.1 Introduction

In the current business environment financial managers have adopted various capital

structures as a means to that goal. A firm can finance its investment by debt and

equity. The use of fixed-charged funds, such as debt and preference capital along with

the owner’s equity in the capital structure is described as financial leverage or gearing

(Dare and Sola, 2010). An unlevered firm is an all-equity firm, whereas a levered firm

is made up of ownership equity and debt (Olweny and Mamba, 2011).

5.2 Summary of Findings and Discussions

According to the findings, statistical analysis of financial performance revealed that

the maximum value of debt to equity ratio is 668.05 while the minimum value is 2.92

while the average for the industry is 56.1817 with a standard deviation of 7. 9495. The

maximum value of portfolio to assets ratio is 59.47 while the average for the industry

is 29.75 with a standard deviation of 54.544. It was revealed further that the

maximum value of operating expense ratio is 24.61 while the minimum value is .52

while the average for the industry is 12.43 with a standard deviation of 3.5256. Return

on Assets had a maximum value of 18.1 and the average for the industry is 9.275 with

a standard deviation of 3.045.

In relation to correlation analysis, the relationship between debt to equity ratio and

various financial performance indicators. The Pearson’s r for the correlation between

the Debt divided Equity ratio and ROA variables is 0.884. This means that there is a

strong positive relationship between the two variables. Since the Sig (2-Tailed) value

34
is less than 0 .05. We can conclude that there is a statistically significant correlation

between the two variables at the 0.01 level. This means that there is a strong

relationship between the two variables.

According to the regression analysis, the findings revealed that 66.3% is explained by

the variables under the study meaning that the model is a good predictor. R=0.814 is

the correlation between the variables which shows that there is a positive correlation

between leverage and financial performance of microfinance institutions in Nakuru

County.

It was observed that the probability value of 0.031 meaning that the regression model

was statically significant in predicting the relationship between financial leverage and

financial performance of microfinance institutions in Nakuru County. From the

regression model, holding all the other factors there exists a direct relationship

between the dependent and the independent variables. The analysis was undertaken at

5% significance level. The criteria for comparing whether the predictor variables were

significant in the model was achieved by comparing the corresponding probability

value obtained and α=0.05. If the probability value is less than α, then the predictor

variable is significant. Therefore, from the above analysis financial leverage was

significant in the model as its corresponding predictor variables were less than 5%.

5.3 Conclusions

From the above findings, it was revealed that there was strong correlation between

leverage and financial performance of microfinance institutions in Nakuru

County.This was evidenced by the Pearson’s r for the correlation between the Debt to

Equity ratio and ROA variables which was 0.884. This means that there is a strong

positive relationship between the two variables. Since the Sig (2-Tailed) value is less

35
than 0 .05. We can conclude that there is a statistically significant correlation between

the two variables at the 0.01 level. This means that there is a strong relationship

between the two variables. The study highly contributes to the determinants of capital

structure by adducing the effect of leverage on financial performance of microfinance

institutions in Nakuru County.

From the study findings, the regression model confirmed that the coefficient of

determination was a good predictor. This is explained by 66.3% of the variables under

study meaning that the model is a good predictor.From the tests of coefficients

holding all the other factors constant, an increase in one unit of the independent

variables (Debt to equity ratio, portfolio to assets ratio and operating expense ratio)

results into a corresponding increase in the dependent variable (ROA).This means that

there exists a direct relationship between the dependent and the independent variables.

The analysis was undertaken at 5% significance level. The study further concludes

that leverage is an appropriate way of financing assets since it’s more likely to boost

the financial performance of the firm from the above findings.

The study concludes that a company with higher operating leverage has the potential

to generate much larger profits than a company with lower operating leverage. For

example, the variable costs for a software company, such as packaging and the cost of

various media devices (like CDs), are very low compared to its fixed costs, such as

research and development. Therefore, once a certain break-even point is reached, the

contribution that sales make to profits is much higher than it would be if a greater

portion of the costs were variable.

The study concludes that leverage is an essential tool which can be a risk if not

properly managed. A risk management plan is a necessary step for firms looking to

36
help use leverage correctly. Managing risk is both the most challenging and the most

important element in business, so it is important for firms to make appropriate

investment decisions and guidance on how to best manage the firms risk profile in

order to enhance financial performance.

The study also concludes that firms should properly manage their risks especially

when they borrow finances to invest in assets.This is because financial leverage can

expose the firms to huge financial losses if they fail to design and develop better ways

of investing borrowed money in projects that can yield better returns in future.

5.4 PolicyRecommendations

The Association of microfinance institutions should set policies to ensure that

microfinance institutions take advantage of leverage to increase their profitability; this

is because by the use of leverage a firm tries to show high result or more benefit by

using fixed costs assets and fixed return sources of capital. It insures maximum

utilization of capital and fixed assets in order to increase the profitability of a firm, it

helps to know the reasons of not having more profit by a company.

Central banks of Kenya should encourage commercial banks to use leverage in

managing risks. This is because the relationship between operating leverage and

financial leverage is multiplicative rather than additive. Operating leverage and

financial leverage can be combined in a number of different ways to obtain a desirable

degree of total leverage and level of total firm risk.

The Association of microfinance institutions should encourage microfinance

institutions to use leverage in designingan appropriate capital structure mix or

37
financial plan. This is one ofthewidely used means of examining the effect of leverage

to analyze the relationship between EBIT and earning per share.

The association of microfinance institutions should conduct regular audits to ensure

that all microfinance institutions maintain a proper balance between debt and equity in

order to ensure that proper debt management practices are effected and the right

investment decisions are made. This will help in regulating microfinance institutions

especially in maintaining proper credit policies and making the right investment

decisions.

The association of microfinance institutions should monitor and supervise

microfinance institutionsto ensure that they invest in profitable ventures especially

when they borrow finances to invest in assets.They should make follow ups to ensure

that microfinance institutions invest in projects that can yield higher returns in the

short run and in the long run.

5.5 Limitations of the Study

This study focused on threevariables only that is debt to equity ratio, portfolio to

assets ratio and operating expense ratio (Independent variables) and financial

performance (dependent variable).Future researchers and academicians should carry

out further research and test more variables for example default ratio and gross loan

portfolio in order to establish whether the relationship between the variables hold.

The study was limited to one county:Nakuru County and therefore the findings and

recommendations made on this study cannot be used to make generalization of other

microfinance institutions operating in the 47 counties in Kenya. It is therefore

important for future researchers to test the same variables on all the microfinance

38
institutions in all the counties, then findings and conclusions can be made based on

concrete facts and evidence.

The cotemporary business environment is characterized by risks and uncertainties due

to its turbulent the macroeconomic factors for example regulations, technology and

other microeconomic factors may affect the current results and thus these findings

may not hold. The study therefore recommends that a study should be conducted after

five years and then findings and conclusions can be compared.

The study used secondary data which is often not presented in a form that exactly

meets the researcher’s needs. This is because secondary data involves past

information which may not be a true reflection of the current needs of the study. This

could have exposed that study to bias and assumptions of the study findings.

The other challenge faced by the researcher was time and cost constraints.The

researcher had to collect the right data to meet the objective of the study within a short

period of time.In addition the researcher had to refine the data to ensure that it

matched the measurement of the study variables. Later the data had to be cleaned,

sorted and coded for analysis.This was however done within a short period of time.

5.6 Suggestions for Further Research

Future researchers may extend study period and may also take all the deposit taking

Sacco that are regulated by SASRA. Researcher can also conduct comparative study

by taking data from deposit taking Sacco’s and Non deposit taking Sacco’s to check

the relationship between financial leverage and financial performance.

The research will provide a direction for further research on other sectors for example

the Nairobi Securities Exchange regarding the impact of financial leverage on the

39
performance of companies operating, measuring a cause and effect relationship. It

may lead to the future researches to be carried out by analyzing the individual

company’s performance and making a comparison with the whole industry by using

the industry performance as bench marks. After measuring the relationship between

the leverage and the financial performance, a further study to measure the significance

of financial leverage for the sector under discussion can be carried out and what

impact it would make on the financial performance if the financial leverage of the

companies is increased or reduced and how the industry players can maximize their

shareholders’ wealth using leverage.

How the firm’s stock value is influenced by using the different levels of leverage and

how companies lying in such sector or the industry players can achieve the

sustainable growth by implementing the leverage concept. What impact the leverage

can make on the sectoral risks and the company specific risks and how to measure,

evaluate, and control the systematic and systematic risks involved for levered

companies in such industry.

Future researcher can consider determining, what impact would the increased risks by

leverage make over the required rate of return of the companies. These are some

questions which may be answered in several studies if future researchers consider

investigating these variables and thus shed more light on how firms can make better

use of leverage to boost their financial performance.

40
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 APPENDIX:LIST OF MFI’s IN NAKURU COUNTY

1. Bimas Ltd

2. Changamka Kenya Ltd.

3. Faulu Kenya Ltd

4. Kenya Women Finance Trust, KWFT.

5. Micro-Kenya

6. Smallholder Irrigation Schemes Development Organization (SISDO)

7. SMEP

Source: Central Bank of Kenya (2011)

46
 APPENDIX II:SECONDARY DATA
EQUITY
2009 2010 2011 2012 2013 min max mean median std dev
INTEREST RATE SPREAD 5.5 7.5 10 6 8.5 6 10 8 8 1.83711731
LEVERAGE na 7.3 8.2 11.4 11.80 7.3 11.8 9.675 9.8 2.2588714
RATIO OF NPLs 0.051 0.0802 0.0528 0.053 0.051 0.051 0.0802 0.0576 0.0528 0.01266965
LIQUIDITY RISK 0.322 0.533 0.456 0.345 0.2 0.2 0.533 0.3712 0.345 0.12824469
ROA na -3 0.2 0.7 0.80 -3 0.8 -0.325 0.45 1.8025445
GDP na 0.056 0.042 0.046 0.053 0.042 0.056 0.04925 0.0495 0.00639661

KWFT

INTEREST RATE SPREAD 13.4 14.4 8.4 8 8 8 14.4 9.7 8.2 3.13900196
LEVERAGE na 10.70 7.90 7.90 8.10 7.9 10.7 8.65 8 1.36991484
RATIO OF NPLs 0.0114 0.1021 0.07 0.06 0.523 0.06 0.523 0.188775 0.0861 0.22353926
LIQUIDITY RISK na 0.0442 0.0442 0.049 0.0513 0.0442 0.0513 0.047175 0.0466 0.00356125
ROA na 1.40 1.30 0.90 0.80 0.8 1.4 1.1 1.1 0.29439203
GDP na na na 0.032 0.043 0.032 0.043 0.0375 0.0375 0.00777817

SMEP
INTEREST RATE SPREAD na 11 12 11.88 13.09 11 13.09 11.9925 11.94 0.8567915
LEVERAGE na 5.3 6.8 2.7 4.9 2.7 6.8 4.925 5.1 1.69386147
RATIO OF NPLs 0.1047 na 0.1 0.19 0.154 0.1 0.19 0.148 0.154 0.04529901
LIQUIDITY RISK na na 0.21 0.3 0.35 0.21 0.35 0.286667 0.3 0.07094599
ROA 0.3 0.3 0.9 2.1 2.4 0.3 2.4 1.425 1.5 0.99121138
GDP na na na 0.0345 0.037 0.0345 0.037 0.03575 0.0358 0.00176777
SUMAC

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INTEREST RATE SPREAD 15.2 8.5 10.4 8.1 8.1 15.2 10.55 9.45 3.25832268
LEVERAGE na 0.00 0.30 0.10 0.20 0.00 0.3 0.15 0.15 0.12909944
RATIO OF NPLs 0.08 0.15 0.07 0.05 0.059 0.05 0.15 0.08225 0.0645 0.04590116
LIQUIDITY RISK na na na 0.21 0.33 0.21 0.33 0.27 0.27 0.08485281
ROA na 5.30 4.60 2.70 5.30 2.7 5.3 4.475 4.95 1.22848145
GDP na na 0.035 0.038 0.039 0.035 0.039 0.037333 0.038 0.00208167

48