IMPACT OF FINANCIAL LEVERAGE ON FINANCIAL

PERFORMANCE: EVIDENCE FROM QUOTED COMPANIES

IN NIGERIA CONSUMER GOODS SECTOR

AUTHOR: Chibueze Augustine GABRIEL

MGS1807596

DEPARTMENT OF ACCOUNTING
FACULTY OF MANAGEMENT SCIENCES
UNIVERSITY OF BENIN
BENIN CITY.

OCTOBER, 2023

1
 IMPACT OF FINANCIAL LEVERAGE ON FINANCIAL
PERFORMANCE: EVIDENCE FROM QUOTED COMPANIES
IN NIGERIA CONSUMER GOODS SECTOR

AUTHOR: Chibueze Augustine GABRIEL

MGS1807596

"Being a Research Project Submitted to the Department of

Accounting, Faculty of Management Science, University of Benin,
Benin City, In Partial Fulfillment of the Requirement for the Award
of Bachelor of Science (B.Sc) Degree in Accounting"

OCTOBER, 2023

2
 DECLARATION
I Gabriel Augustine Chibueze hereby declare that:

This project study is based on a study undertaken by me in the Department of Accounting

under the supervision of Prof O. O. Omokhudu

This work has not been previously submitted for the award of a degree elsewhere

All ideas and view are products of my personal research and where the views of others
have been used and expressed, they were duly acknowledged.

Chibueze Augustine GABRIEL

3
 CERTIFICATION
We the undersigned certify that this project was carried out by Chibueze Augustine GABRIEL in
the Department of Accounting, University of Benin, Benin City and approved as adequate in
score, content and quality in partial fulfilments of the requirement for the award of Bachelors of
Science (B.Sc.) Degree in Accounting.

Prof. O. O. Omokhudu Date

Project Supervisor

Dr. Ikhu Omoregbe God'stime Date

Project Coordinator

Dr. Osasu Obarenti Date

Head of Department

4
 DEDICATION
I dedicate this project to Almighty God, the giver of knowledge for His diet of blessings upon
me. To my living parents, Mr. and Mrs. Gabriel Obi for their financial, moral and spiritual
support. Thanks for always being there for me and for all your encouragement, advice and
prayers.

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 ACKNOWLEDGEMENT
In the course of this study, I got a lot of overwhelming support and encouragement from various
areas and I would like to acknowledge with a deep sense of appreciation. Firstly, all thanks to
God for His infinite mercy and grace.

I also appreciate my supervisor, Prof. O. O. Omokhudu for his painstaking efforts in going
through our work, his corrections and helpful suggestions.

My profound gratitude to my parents, Mr. and Mrs. Gabriel Obi and my siblings.

Special thanks to Deborah Ajoke, Victor Agbaiza, Deborah Bassey, Dorothy Ezekiel for your
advice, care and moral support. God bless you all abundantly.

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 TABLE OF CONTENTS
PAGES
Cover page i

Title page ii

Declaration iii

Certification iv

Dedication v

Acknowledgement vi

Table of Contents vii

Abstract ix

CHAPTER ONE INTRODUCTION

1.1. Background to the study 1

1.2. Research Questions 2

1.3. Objective of the Research 3

1.4. Research Hypothesis 3

1.5. Scope of the Study 3

1.6. Significance of the Study 3

CHAPTER TWO: LITERATURE REVIEW

2.1. Conceptual Review 4

2.2. Empirical Review 16

2.3. Theoretical Review 18

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CHAPTER THREE: METHODOLOGY

3.1. Research Design 24

3.2. Population and Sampling 24

3.3. Sources of Data 24

3.4. Model Specification 24

3.5. Method of Data Analysis 25

3.6. Operationalization of Variables 26

CHAPTER FOUR: DATA REPRESENTATION AND ANALYSIS

4.1. Model Fit 28

4.2. Regression Analysis and Interpretation 31

CHAPTER FIVE: SUMMARY OF FINDINGS, CONCLUSION AND

RECOMMENDATION 35

REFERENCES 36

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 ABSTRACT
This paper evaluated the relationship between financial leverage and financial performance using
selected quoted consumer goods companies in Nigeria. The study employed secondary data
which were gathered from the yearly reports of selected firms. A sample of 13 firms were
selected purposely out of the entire listed consumer goods firms on the Nigerian Stock Exchange
(NSE). This was done based on the availability of annual reports of the chosen firm for the
period of 2018-2022.

A structural equation model was employed to find out the relationship between financial
leverage and financial performance through the use of AMOS 26.0.0. The finding revealed the
independent variables which are debt-equity (DER), asset-equity (AER) and degree of financial
leverage (DFL) has a positive significant effect on the dependent variables which are return on
assets (ROA), return on equity (ROE) and earnings per share (EPS).

It was recommended that since the major aim of firms is to make profit and increase shareholders
wealth, firms should ensure that leverage level is maintained at the optimum since high leverage
will bring high interest and reduce firm profit. In addition firms should increase the equity
portion of their debt to equity mix in order to reduce debt to equity gap and improve financial
performance.

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1. INTRODUCTION
1.1 Background To The Study

Financial performance, in a broader sense, relates to the extent to which financial objectives have
been met and is an important part of finance risk management. It is the process of calculating the
monetary outcomes of a company's policies and operations. It is used to assess a firm's overall
financial health over a certain time period and can also be used to compare similar enterprises
within the same industry or to compare industries or sectors in aggregate. A firm's financial
success demonstrates its proficiency in employing the resources at her disposal to maximize
shareholder wealth and generate more profitability.

There are numerous variables which influences a firm's financial performance of which a key
factor is leverage, hence their relationship is worth exploring. Every firm, whether sole
proprietorship, partnership, or limited liability company, has an approach enabling the owners to
fund it. The capital structure of an organization outlines its numerous sources of financing. This
structure can take the form of share capital and reserves, which we refer to as shareholders'
funds, in addition to long-term loans, which we commonly refer to as gearing or leverage. The
latter source, leverage, is the topic of this study, and it is viewed as a measure demonstrating the
extent to which a firm's activities are funded through owners funds as opposed to external
investment.

The advancement of financial markets in which funds can be generated has further complicated
the process of generating capital for executive bodies, the end goal of which is to optimize
performance of the business. Debt and equity have evolved into their own terms and meanings,
with debentures, bonds, loans, running finances, ordinary shares, preferred shares, and retained
earnings being the extra divisions formed for these sources. Finance managers are expected to
select the best choice for funding a given resource and strike the proper balance that can
minimize costs while increasing earnings for shareholders. There are multiple schools of thought
that have put forward arguments on the ideal level of leverage for a corporation. The optimal
posture can be determined by weighing the cost of bankruptcy against the tax benefit that
corporations gain from charging interest payments. (2013) (Owolabi and Inyang).

The capital structure is vital to both the firm's management and its shareholders. This is owing to
the fact that utilizing an inappropriate blend of finance may exert detrimental effects on the
firm's performance and survival. Leverage, frequently referred to as gearing, allows stockholders
envision a higher profit than would otherwise be achievable; nonetheless, the potential risk can
sometimes be higher. In a nut shell, assuming the investment was a waste of time, the borrowed
capital and all interest must be repaid (Gweyi and Karanja, 2014). Any effort by a company to
establish a financial combination must be held with two proposals in mind: first, the capital
structure should be designed in a way that meets the objective of optimizing shareholders equity,
10
and second, the optimal capital structure should be approximated as best as possible (Orajaka,
2017). Firms must therefore balance the perks of debt against the drawbacks of debt when
seeking to boost their financial performance (Abubakar, 2016).

Since the pioneering work of Modigliani and Miller in 1958, the ideology of a firm's leverage
relationship with its performance has remained a topic of debate. They deemed the debt-to-equity
ratio had no bearing on a company's worth. However, as they examined the conditions of perfect
markets, no taxes, and the absence of transaction and bankruptcy costs, the debt irrelevance
theory is hardly conceivable. Modigliani and Miller (1963) later loosened the no-tax assumption
and established a theory of debt tax benefits. That paper sparked a substantial academic debate
over the theory of financial leverage (Iavorskyi, 2013). There are, however, some costs
connected with debt financing. A specific debt to equity mix must be determined between the
two extremes of whole-equity financing and whole-debt financing. In response, researchers and
financial specialists analyze the impact of financial leverage on financial performance in order to
validate theoretical predictions and pinpoint the optimal debt-to-equity mix that firms ought to
employ to improve financial performance.

Rashidah (2018), Mohammad (2014), Rajkumar (2014), Ahmadu (2015), Abu-Abbas (2017),
Abubakar & Garba (2018), Dey, Hossain & Rahman (2018), Laila & Rehana (2018), Kenn-
Ndubuisi & Nweke (2019), Kithandi (2019), Okoye (2019), Ripon, Syed & Desta (2020), among
other researchers have conducted research on leverage and financial performance. These
academics have all expressed opposing views as to the relationship between leverage and
profitability, creating a gap in this research. Some research suggest a favorable relationship,
among which are Dey, Hossain, and Rahman (2018), Laila and Rehana (2018), and Mohammad
(2018). Others, such as Kithandi (2019), Abubakar and Garba (2018), Rajkumar (2014), and
Abu-Abbas (2017), demonstrated an inverse relationship. Again, reviewed research by Okoye
(2019), Desta (2020), Syed (2013), Kenn-Ndubuisi & Nweke (2019), and Ripon, Syed, &
Rashidah (2018) all yielded mixed results, while Ahmadu (2015) indicated that there was no
association between leverage and financial performance.

1.2 Research Question

This study attempts to answer the following questions:

The nature of financial leverage and by what method is it evaluated?

What precisely is financial performance? How is it estimated?

Is there a relationship between financial leverage and financial performance?

If there is, is it a positive or negative relationship?

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1.3 Objectives of the Research

The major objective of this study is to inquire into the relationship between financial leverage
and financial performance using selected Nigerian listed consumer goods firms,

1.4 Research Hypothesis

H0: There is no significant relationship between financial leverage and financial performance.

H1: There is a significant relationship between financial leverage and financial performance.

1.5 Scope of the Study

The area of focus of this study is confined to listed consumer goods firms on the Nigeria stock
exchange owing to the study's depth.

1.6 Significance of the Study

The study will give an in-depth analysis of the relationship between financial leverage and
financial performance. It will add to the existing literature by defining best practices for
managing financial leverage while offering empirical evidence on the factors that influence the
relationship between financial leverage and financial performance. The research effort will be
beneficial to investors, managers, policymakers, and other financial market stakeholders.

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2. LITERATURE REVIEW
2.1 Conceptual Review

2.1.1 Financial Performance

Financial performance refers to the measurement of a company's overall financial health,

strength, and profitability. It comprises evaluating various aspects of a company's financial
statements such as revenue, expenses, profit margin, return on investment, and liquidity.
Financial performance analysis is crucial for companies to identify their areas of strength and
weaknesses, and to make informed decisions for future growth.

Financial performance is a crucial element in assessing the success and stability of an

organization. It encompasses various financial metrics and indicators that help stakeholders,
including investors, lenders, and management, to evaluate a company's profitability, growth
potential, and overall financial health.

Financial performance can be measured in several ways such as revenue and profitability, return
on investment (ROI), financial ratios, cash flow analysis, comparative analysis and trend
analysis. Evaluating financial performance comes with many benefits. It provides a clear picture
of a company's overall financial health, thereby allowing management to make informed
decisions regarding future investments, resource allocation, expansion plans, and cost-cutting
strategies. Accurate financial insights help identify areas of improvement and guide strategic
planning for business growth (Djamaludin, 2020). Investors and lenders rely on financial
performance measures to assess a company's creditworthiness and gauge potential risks. A strong
financial performance can attract more investment and favorable loan terms (Correia et al.,
2020). Analyzing financial performance allows companies to benchmark their performance
against industry standards and competitors. It helps identify areas where they excel or lag behind,
leading to strategic adjustments to enhance their competitive position (Bodie et al., 2017).

Several studies has been carried out on financial performance. A study by Farooq et al. (2019)
analyzed the financial performance of selected companies in the Indian pharmaceutical sector.
The study found a strong correlation between financial performance and shareholder wealth,
indicating that financial performance is a critical determinant of a company's success. A study by
Al-Shubiri and Al-Shubiri (2020) investigated the impact of financial performance on firm
survival using a sample of Jordanian companies. The study found that companies that exhibited
strong financial performance were more likely to survive than those with poor financial
performance.

Financial performance is critical for companies' success and survival. Measuring and evaluating
financial performance is essential for businesses to understand their strengths, weaknesses, and
opportunities for improvement. Various metrics and ratios, including revenue, profitability, ROI,
13
liquidity, debt, and cash flow analysis, provide valuable insights into a company's financial
health and future prospects. By effectively assessing financial performance, organizations can
make data-driven decisions, attract investment, ensure financial stability, and achieve long-term
success.

2.1.2 Financial Leverage

According to Franco Modigliani and Merton Miller (1958) theory of capital structure, financial
leverage refers to the use of debt financing in a firm's capital structure in order to maximize the
value of the firm. Financial leverage measures the extent to which a company employs debt
financing relative to its equity financing (Ross, Westerfield, and Jordan (2019).

By employing borrowed funds, companies can utilize leverage to generate higher returns on
investment. This allows them to magnify profits and, in turn, increase shareholder value (Donald
B. Roper, 1968). Furthermore, financial leverage provides a means to access additional capital
when needed, enabling companies to fund expansion plans, research and development, and other
growth-related activities (Richard Brealey and Stewart Myers, 1991). Leveraging debt helps
prevent dilution through equity issuance and maintain control over the company's ownership.
Also, interest paid on debt is tax-deductible in most jurisdictions. By using debt financing,
companies can lower their tax liability, thereby enhancing their after-tax profits and cash flows.

However, along with the benefits comes costs. An excessive reliance on debt increases a firm's
financial risk as it increases the repayment obligations and interest expenses (Aswath
Damodaran, 2012). During economic downturns or periods of financial instability, servicing debt
may become challenging, leading to potential liquidity issues and distress. If a company is
unable to meet its debt obligations, it may face bankruptcy or liquidation. High leverage ratios
amplify the consequences of economic shocks, market downturns, or company-specific issues,
making it crucial for businesses to maintain a prudent balance between debt and equity. The cost
and availability of debt financing depend on a company's credit rating. High levels of debt may
lead to downgrades, raising borrowing costs and hindering future financing options.

Financial leverage has a considerable impact on ROE, as it magnifies profits generated by the
use of borrowed funds. It allows companies to achieve higher financial performance and create
value for shareholders (Stewart c. Myers, 1977). Financial leverage affects a company's EPS by
amplifying profits. Debt financing can lead to higher interest expenses, which may reduce EPS
and be a concern for shareholders. However, if the returns on investments exceed the cost of
debt, EPS can be positively influenced (Eugene F. Brigham and Joel F. Houston, 1991).

Financial leverage increases a company's debt-to-equity ratio by raising the level of debt in their
capital structure. A higher debt-to-equity ratio signifies higher financial risk and may impact
creditors' perception of a firm's creditworthiness. Financial leverage, when appropriately
managed, plays a pivotal role in enhancing a company's growth prospects, profitability, and
14
shareholder value. It enables businesses to access additional capital, magnify returns on equity,
and benefit from tax advantages. However, excessive leverage can expose firms to financial
fragility and risks. Striking a balance between debt and equity, considering industry-specific
characteristics and financial objectives, is crucial to mitigate risks associated with financial
leverage.

2.1.3 Measures Of Financial Performance

Financial performance is an overall assessment of a company's position in the fields related to

assets, liabilities, equity, expenses, revenue, and overall profitability. It is calculated using a
variety of business-related algorithms that allow users to calculate precise details about a
company's prospective effectiveness. Financial performance is analyzed by internal users to
determine the well-being and standing regarding their respective firms, among other
benchmarks. External users assess financial performance to determine prospective investment
opportunities and if a company is worth their while. The measures of financial performance can
be categorized into financial measures and non-financial measures.

There are numerous researchers and academics who have studied and provided their views on the
major measures of financial performance. A few of them are started below:

In the early 1990s, Kaplan and Norton introduced the Balanced Scorecard as a comprehensive
measure of financial performance. They argued that financial indicators alone are insufficient to
assess performance and proposed including non-financial measures related to customers, internal
processes, and learning and growth.

In 1993, Eugene Fama and Kenneth French developed the Fama-French Three-Factor Model,
which expanded on the traditional Capital Asset Pricing Model (CAPM) to include additional
risk factors (size and value) in evaluating financial performance.

In 1976, Jensen and Meckling introduced the concept of agency theory. They argued that
financial performance should be evaluated based on how well management aligns shareholder
interests with their own. They proposed using measures like shareholder value or economic value
added (EVA) to assess managerial performance.

In 1984, R. Edward Freeman introduced stakeholder theory as an alternative approach to

evaluating financial performance. He argued that businesses should consider the interests and
impact of various stakeholders, including employees, customers, suppliers, and communities,
rather than solely focusing on shareholder value.

In 2004, Mahendra Gupta, Kale, and Son Y. Shin conducted research on the financial
performance measures for companies in the airline industry. They examined various profitability
measures, such as return on assets (ROA), return on equity (ROE), and operating profit margin,
to assess the financial performance of different airlines.
15
From the above researches, financial performance measures can be grouped into financial and
non-financial measures.

Financial measures:

A financial statement analysis is required before calculations on key financial indicators that
indicate overall performance can be completed. Financial statement analysis is a process that
both internal and external stakeholders use to acquire a better understanding of how a firm is
operating. The procedure entails examining four essential financial documents in a business: the
statement of cash flows, the statement of financial position (previously referred to as the balance
sheet), the income statement, and the annual reports. Certain financial formulas and ratios are
calculated during a financial performance analysis, and when compared to historical and industry
data, they provide insight into a company's financial state and performance.

The ratios that will be focused on for the purpose of this study are return on equity (ROE), return
on asset (ROA) and earnings per share (EPS). This is in accordance with the paper published by
John Dearden, William F. Meek, and Michael C. Ohlson titled "Accounting-Based Measures of
Corporate Performance: A Simulation" in 2000. They argue that financial measures, such as
earnings per share, return on equity, and return on assets, are crucial indicators of firm
performance and should be carefully examined by investors.

Return on asset

Return on Assets (ROA) is an essential financial indicator that measures a company's efficiency
in generating profits from its total assets. It measures how effectively a company utilizes its
assets to generate earnings or income. This metric has significant implications for investors,
lenders, and management since it provides insights into a company's profitability, efficiency, and
overall financial health. Eugene F. Fama (1965) defined the return on an asset as the change in
its price, plus any income received from the asset, such as dividends or interest payments, over a
specific period.

ROA is calculated by dividing a company's net income by its total assets (Net Income / Average
Total Assets). The resulting percentage represents how well a company is utilizing its assets to
generate income. A higher ROA implies that a company is generating more income per dollar of
assets.

The importance of ROA lies in its ability to compare the efficiency and profitability of different
companies within the same industry or sector. It allows investors to assess how efficiently
management utilizes a company's assets to generate returns. A higher ROA indicates the
company is generating better returns on its investments, which is generally more attractive to
potential investors and lenders.

16
It is essential to note that different industries have varying average ROA benchmarks. Thus, to
interpret ROA accurately, it is crucial to compare a company's performance against similar
companies or the industry average.

William F. Sharpe (1966): Sharpe introduced the concept of the risk-adjusted return, known as
the Sharpe Ratio. According to Sharpe (1996), the return on an asset should be adjusted for the
risk taken to achieve that return. Harry Markowitz (1952) developed the modern portfolio theory,
which considers the return on an asset as a part of a diversified portfolio. He suggested that
returns should be analyzed in terms of their contribution to the overall portfolio's risk and return.

John Lintner (1965): Lintner's research focused on the relationship between an asset's expected
return and its risk. He developed the Capital Asset Pricing Model (CAPM), which estimates an
asset's expected return based on its beta, a measure of systematic risk.

Overall, ROA provides significant insights into a company's financial performance and
efficiency. It helps investors and stakeholders assess management's ability to generate profits
from the assets at their disposal. By analyzing trends in ROA over time and comparing it to
industry benchmarks, investors can make more informed decisions regarding investments, while
company management can identify areas for improvement in maximizing returns on their assets.
Here are three research studies that discuss the use of return on assets (ROA) as a measure of
financial performance:

"The Impact of Financial Performance on Firm Value: Evidence from Emerging Economies"
(2019) by Ratan Ghosh and Indrajit Mukherjee. This study examines the relationship between
financial performance and firm value in emerging economies. They find that ROA has a
significant positive impact on firm value, indicating that higher ROA leads to higher market
valuation. The research covers the years 2006 to 2016.

"Return on Assets as a Measure of Organizational Performance among Top Performing

Companies in Malaysia" (2017) by Siti Khatijah Nor Abdul Rahim, Nur'Aini Osman, and
Tengku Azmi Tengku Abdullah: This study focuses on the use of ROA as a performance
measure specifically for top-performing companies in Malaysia. They argue that ROA reflects a
company's profitability and efficiency in asset utilization. The research analyzes the data from
the year 2013.

"The Relevance of Return on Assets as a Performance Measure in the Context of German Non-
Profit Organizations" (2015) by Tobias Birkner and Helmut Kasper: This study investigates the
applicability of ROA as a performance measure for non-profit organizations in Germany. The
authors argue that while ROA is commonly used in the for-profit sector, it may not accurately
reflect the performance of non-profit organizations due to their unique objectives and resource
allocation practices. This research focuses on the year 2014.

17
Return on equity (ROE)

Joel Greenblatt (2005) defined Return on equity (ROE) as a financial metric used to measure a
company's profitability by calculating the amount of net income generated as a percentage of
shareholders' equity. ROE is a measure that demonstrates how effectively a company utilizes its
resources to generate profits for its shareholders (Warren Buffett, 2014) . It is calculated by
dividing net income by shareholders' equity (Net Income / Average Shareholders' Equity) * 100

A higher ROE is generally considered more favorable, as it indicates efficient utilization of

capital and a higher return for shareholders. Conversely, a lower ROE suggests poor profitability
or inefficient capital management.

Companies can increase their ROE by either increasing their net income or by managing their
equity more efficiently. Efficient equity management can be achieved through various strategies,
such as leveraging debt, reducing unnecessary equity, and improving operational efficiency.

However, ROE has its limitations. It may not be a reliable measure for companies with
fluctuating profitability or those in cyclical industries. Additionally, industries with high capital
requirements, such as manufacturing or infrastructure, may have lower ROE due to their large
equity base.

Overall, ROE is a valuable metric for evaluating a company's profitability and the effectiveness
of its equity utilization (Richard Roll, 2018). It provides insights into a company's ability to
generate returns for its shareholders (Joseph Piotroski, 2020). However, it should be used in
conjunction with other financial ratios and considerations to gain a holistic view of a company's
financial health and prospects. The following researchers gave their opinion on return on equity
as a measure of financial performance in their study.

Eugene F. Fama and Kenneth R. French (2004). In their research paper titled "The Capital Asset
Pricing Model: Theory and Evidence," the authors argued that return on equity (ROE) is a valid
and commonly used measure of financial performance. They believed that ROE helps assess the
firm's ability to generate profits from its shareholders' investments.

Dechun Wang and Kai Li (2004): In their paper titled "When Are Outside Directors Effective?"
Wang and Li examined the role of return on equity as a measure of financial performance in
corporate governance. They found that a higher ROE is positively associated with the
effectiveness of outside directors in monitoring the management.

Tommy H. Davis and Colin M. Lizieri (2009): In their research article titled "Real Estate
Investment Trusts: Statistical Properties of Return on Equity," Davis and Lizieri aimed to
determine the statistical properties of the return on equity (ROE) metric for real estate investment
trusts (REITs). They analyzed the relationship between ROE, firm characteristics, and market
conditions.
18
Ramesh K. S. Rao and Subhash C. Sharma (2016): In their research paper titled "Return on
Equity of Indian Pharmaceutical Companies: A Comparative Study," Rao and Sharma analyzed
the ROE of Indian pharmaceutical companies. They compared the financial performance of
different firms in the industry based on ROE ratios.

Earnings per share

Davis & Walsh (2000): Defined earnings per share (EPS) as a financial metric that indicates the
portion of a company's profit allocated to each outstanding share of common stock in a specific
time period. It is widely used by investors, analysts, and shareholders to assess a company's
financial health and to compare its performance to other companies within the industry. EPS is
calculated by dividing the net earnings of a company by the total number of outstanding shares.

EPS = net earnings/outstanding shares

The net earnings, also known as the net income, refer to the profit earned by a company after
subtracting all expenses, taxes, and interest payments from its total revenue. The total number of
outstanding shares represents the total number of shares owned by all shareholders, including
both common and preferred stockholders. EPS can be reported in two forms: basic EPS and
diluted EPS. Basic EPS is calculated by dividing the net earnings by the actual number of
outstanding common shares. Diluted EPS takes into account the potential dilution effect on EPS
if all convertible securities (such as stock options, convertible bonds, or preferred shares) were
exercised. Diluted EPS gives a more conservative measure of a company's profitability.

However, it is important to note that EPS has its limitations. EPS can be influenced by several
factors, including seasonality, cyclical trends, or one-time events. Therefore, it may not always
accurately reflect a company's ongoing profitability. EPS can be manipulated through accounting
practices such as changes in revenue recognition or expense management. Therefore, investors
should consider other financial indicators and perform a thorough analysis of a company's
financial statements to assess its overall financial health (Elizabeth A. Gordon, 2020).
Companies can artificially increase EPS by repurchasing their own shares, reducing the number
of outstanding shares. While this may boost EPS, it does not necessarily reflect an improvement
in the underlying business performance (Osiatynski, 2018). Numerous researchers have studied
earnings per share (EPS) as a measure of financial performance. Here are a few notable ones:

Fama, E. F., & French, K. R. (2005) analyzed the relationship between EPS and stock returns.
They found that high earnings per share growth tends to lead to higher future stock returns. Lev,
B. (2003) research examines the usefulness of EPS as a measure of firm performance. He argues
that EPS can be manipulated through accounting practices, making it an unreliable indicator of a
firm's true financial performance. Dechow, P. M., Sloan, R. G., & Sweeney, A. P. (1996)
investigated the quality of earnings and the reliability of EPS. They identify earnings
manipulation practices that can distort EPS and mislead investors. Hope, O. (2003) scrutinized
19
the relationship between earnings management and EPS. He finds evidence that companies
engage in earnings manipulation to meet EPS targets, which can misrepresent their financial
performance. Callen, J. L., & Morel, M. (2017) examined the impact of EPS on stock price and
market valuation. They find a positive relationship between EPS and stock price, suggesting that
investors value high EPS.

Non-Financial measures

Non-financial measures of corporate performance refer to a broad set of indicators that a

company uses to evaluate its success beyond just the financial bottom line (Ittner and Larcker,
1998) . While financial performance metrics, such as revenue, profit, and return on investment,
are widely recognized as important, non-financial measures provide a more holistic view of a
company's overall performance and help in understanding the underlying factors driving
financial results. These measures are often referred to as Key Performance Indicators (KPIs) and
are typically aligned with a company's strategic goals and objectives. The growing importance of
non-financial measures can be attributed to several reasons. First, traditional financial metrics
may not capture the full extent of a company's value creation. Non-financial measures enable
organizations to assess their performance from various perspectives, including customer
satisfaction, employee engagement, innovation, sustainability, and social impact (Kaplan and
Norton, 1996). Second, these measures provide insights into the long-term sustainability and
future prospects of a company, as they focus on important intangible assets and capabilities, such
as brand reputation, customer loyalty, and talent development (Eccles and Pyburn, 1992). Lastly,
non-financial measures are increasingly demanded by stakeholders, including investors,
regulators, customers, and employees, who are interested in understanding a company's impact
on society and the environment, as well as its non-financial risks and opportunities.

There are several categories of non-financial measures that companies can consider when
assessing their performance (Ittner and Larcker, 1998)

Customer-related measures: These measures focus on customer satisfaction, loyalty, and

retention. Examples of KPIs include customer satisfaction scores, Net Promoter Score (NPS),
customer churn rate, and repeat purchase rate. These metrics provide insights into how well a
company meets customer needs, builds relationships, and differentiates itself from competitors.

Employee-related measures: These measures assess employee performance, engagement, and

development. KPIs in this area include employee satisfaction surveys, turnover rates, training
and development hours, and diversity and inclusion metrics. Employee-related measures are
important, as engaged and motivated employees are more likely to deliver superior performance
and contribute to innovation and organizational success.

Operational measures: These measures focus on the efficiency and effectiveness of a company's
operations. KPIs within this category include process cycle time, product defect rates, inventory
20
turnover, and production yield. Operational measures help identify bottlenecks, waste, and
opportunities for improvement, enabling companies to optimize their processes and reduce costs.

Innovation and learning measures: These measures assess a company's ability to drive
innovation, adapt to changes, and continuously learn and improve. KPIs in this area could
include research and development (R&D) investment, new product launches, patents filed, and
employee ideas implemented. Innovation and learning measures are crucial, as they reflect a
company's long-term ability to stay competitive and innovate in an ever-changing business
landscape.

Social and environmental measures: These measures evaluate a company's impact on society and
the environment. KPIs in this category encompass greenhouse gas emissions, energy and water
consumption, waste management, community engagement, and employee safety records. Social
and environmental measures are increasingly important to stakeholders, as they demonstrate a
company's commitment to sustainability and responsible business practices.

Governance and ethical measures: These measures assess a company's adherence to codes of
conduct, ethical standards, and regulatory compliance. KPIs within this category include
measures of board independence, audit committee effectiveness, whistle-blower reports, and
legal and regulatory violations. Governance and ethical measures help assure stakeholders that a
company operates with integrity and transparency, reducing reputational and legal risks.

Non-financial measures of corporate performance are essential for providing a comprehensive

assessment of a company's success and value creation. By incorporating these measures,
companies can better understand their performance from multiple angles, align their strategies
and operations with long-term goals, and meet the expectations of various stakeholders.
Companies that effectively measure and manage their non-financial performance are more likely
to outperform their competitors and build sustainable, responsible businesses.

2.1.5. Measures Of Financial Leverage

The goal and outcome of financial leverage is to multiply a project's potential returns. At the
same moment, leverage increases the potential downside risk if the investment fails to work out.
When a company, property, or investment is termed as "highly leveraged," it implies that it has
more debt than equity. A broad range of leverage financial measures are used in determining
how much debt a company is leveraging in order to optimize earnings.

A leverage ratio is any financial ratio that compares the amount of debt incurred by a company to
other accounts on its statement of financial position, income statement, or cash flow statement.
These ratios show how the company's assets and business operations are financed (through debt
or equity). Market analysts, investors, and lenders may take into account a variety of leverage

21
ratios. Total assets, total equity, operating expenses, and incomes are some accounts that are seen
to be highly comparable to debt. This study will focus on three following three leverage ratio:

Debt-equity ratio

The debt to equity ratio is a financial metric used to measure the relative proportion of a
company's total debt to its shareholders' equity. It provides insights into a company's financial
leverage, risk profile, and capital structure. This ratio is popularly used by investors, creditors,
and analysts to assess a company's solvency, financial stability, and ability to meet its financial
obligations.

The formula for calculating the debt to equity ratio is as follows:

Debt to Equity Ratio = Total Debt / Shareholders' Equity

"Total Debt" refers to the sum of all outstanding borrowings and obligations that a company
owes to external parties, including long-term and short-term debt, loans, bonds, and other
liabilities. On the other hand, "Shareholders' Equity" represents the residual value of a company's
assets after deducting all its liabilities. A high debt to equity ratio implies that a company has a
higher level of debt in proportion to its equity, indicating a higher financial risk and potential
difficulty in repaying debt. Conversely, a lower debt to equity ratio suggests a lower level of
financial risk and a stronger balance sheet. Here are some key points to consider about the debt
to equity ratio:

Assessing financial risk: The debt to equity ratio provides an indication of the financial risk
associated with a company. Higher debt levels can increase interest obligations and reduce cash
flow available for investment or other business activities (Scott, J. H., & Martin, P. R., 1997). A
higher ratio may indicate increased financial distress, as the company may struggle to meet its
debt obligations.

Comparing industry standards: The debt to equity ratio can be used to compare a company's
financial leverage with industry competitors or standards. Different industries have varying
levels of debt usage, and a company's ratio may be considered high or low depending on the
sector it operates in (Damodaran, A., 2016).

Impact on cost of capital: A higher ratio may increase a company's cost of capital since lenders
or investors may demand higher interest rates or returns to compensate for the additional
financial risk associated with high debt levels (Altman, E. I., 1968). Conversely, a lower ratio
may result in lower borrowing costs and improve the company's ability to raise capital at
favorable terms.

Investment decision-making: The debt to equity ratio is valuable information for investors when
evaluating a company's attractiveness for investment. A company with a moderate debt to equity
22
ratio may indicate a balanced capital structure, while a high ratio requires careful analysis of the
company's ability to service its debt and generate sufficient earnings.

Variations in capital structure: Some industries, such as utilities or capital-intensive sectors like
manufacturing, tend to have higher debt to equity ratios due to the need for significant
investment in assets. Service-based industries or technology companies often have lower ratios
as they typically require less capital investment.

The debt to equity ratio should not be viewed in isolation but considered in conjunction with
other financial metrics and qualitative factors. It does not consider the nature or terms of the
debt, such as interest rates or maturity dates, which are crucial factors in assessing risk.
Additionally, it does not reflect the potential growth prospects, profitability, or industry
dynamics that may influence investment decisions.

Asset-equity ratio

The asset to equity ratio is a financial measure that indicates the leverage, or the extent to which
a company's operations are funded by debt relative to shareholders' equity (R.C. Merton,1974). It
is calculated by dividing total assets by total equity.

There are several researchers who have studied the asset to equity ratio as a measure of financial
leverage. Here are a few notable examples and their respective views on this ratio:

E. F. Brigham and J. F. Houston (2013). In their book "Fundamentals of Financial Management,"

Brigham and Houston state that the asset to equity ratio is an indicator of the degree of financial
leverage and riskiness of a firm. They argue that a higher ratio implies a higher level of financial
leverage, which can enhance returns on equity when things go well but can also lead to greater
losses and bankruptcy risk when things go poorly.

Ross, Westerfield, and Jordan (2015): In their textbook "Corporate Finance," Ross et al. view the
asset to equity ratio as a measure of financial leverage for a company. They argue that higher
leverage can increase the company's return on equity, as it allows for amplification of profits
through the use of borrowed funds. However, they also note that higher leverage increases a
company's risk of financial distress and potential bankruptcy.

Michael C. Jensen (1986): Jensen is known for his research on agency theory and corporate
finance. In his article "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers,"
Jensen suggests that a high asset to equity ratio can lead to excess free cash flow, which can be
misused by managers and result in agency costs. He argues that shareholders can mitigate these
costs by implementing appropriate restrictions on financial leverage.

Degree of financial leverage (DFL)

23
The degree of financial leverage (DFL) is a financial metric used to measure the sensitivity of a
company's earnings per share (EPS) to changes in its earnings before interest and taxes (EBIT).
It measures the impact of changes in the operating profit of a company on its net income and,
consequently, on its shareholders' equity. DFL is calculated by dividing the percentage change in
EPS by the percentage change in EBIT. It reflects the company's ability to utilize debt and
interest payments to magnify the impact of changes in operating profit on its bottom line. A
higher DFL indicates a higher financial risk, as a small change in operating profit can have a
significant impact on the company's net income and, therefore, on the returns to shareholders.

Understanding the DFL is crucial for investors and financial analysts as it provides insights into
a company's financial risk and its ability to generate returns. A higher DFL implies that the
company has a greater reliance on debt, which can be advantageous in good economic conditions
when the company is generating high profits. However, in times of economic downturn or
declining profits, a higher DFL can amplify the negative impact on earnings, potentially leading
to financial distress.

By contrast, a lower DFL implies a lower level of financial risk, as the company has a smaller
portion of debt in its capital structure. This can provide stability and flexibility in managing the
company's financial obligations, reducing the risk of default on debt payments and potential
bankruptcy. The DFL of a company is influenced by several factors, including its capital
structure, interest rates, operating leverage, and industry dynamics. Companies with high fixed
costs and low variable costs have a higher operating leverage, which can increase their DFL.
Additionally, industries with high levels of competition and volatility may also have higher
DFLs, as they are more exposed to changes in operating profits. Investors and financial analysts
use the DFL to assess the financial health and stability of a company, especially when comparing
it to its peers or benchmark indices. A higher DFL may indicate a riskier investment, particularly
if the company is already highly leveraged and has limited capacity to service its debt
obligations. On the other hand, a lower DFL may indicate a more conservative and stable
investment option. It is essential to note that the DFL is just one of many financial metrics used
to evaluate a company's financial leverage and risk. It should be considered alongside other key
ratios, such as the debt-to-equity ratio, interest coverage ratio, and return on equity, to get a
comprehensive understanding of a company's financial position and risk profile.

2.2 Empirical Review

Several studies conducted by numerous researchers on this topic has yielded various conclusions.
A study was conducted by Okoye (2019) regarding the relationship between financial leverage
and financial performance on selected Money Banks in Nigeria within the period of 2005-2017
24
using debt-equity ratio, debt ratio as indicators for financial leverage and return on equity as
proxy for financial performance and size of the institution proxied by total assets are used as
control variable. Data was collected from the annual financial statement of accounts of the
selected banks. The result from the correlation analysis and OLS regression discovered that there
is a significant negative relationship between return on equity and debt-equity ratios. The
findings also indicated that the relationship between return on equity and debt ratio is negative
and insignificant while that of size proxied by total assets is significantly positive. Furthermore,
findings from the descriptive analysis show that about 84% of total assets of deposit money
banks in Nigeria are financed by debt. The study concluded that deposit banks in Nigeria are
highly geared.

Kenn Ndubuisi and Nweke (2019) studied the relationship between financial performance and
financial leverage using 80 non-financial firms quoted on the Nigerian Stock Exchange from
2000 to 2015. Panel analysis methodology has been implemented to analyze theories in the
context of pooled correlation model, fixed effect model, random effect model and marginal
model. The research showed that earnings per share are important and negatively linked to the
debt-to-equity ratio and overall debt to total asset measures of financial leverage whereas return
on equity has an insignificant relationship with the financial leverage measures in Nigeria while
the orientation of the association varies from one variable to a another. It was optimistic with the
overall debt-to-capital ratio and interest expenses while the gross debt-to-account ratio, long term
debt-to capital ratios and the interest-to-account ratio were negative.

In agreement to this, another study conducted by Ripon, Syed and Rashidah (2018) established a
negative relationship between leverage and firm performance. They analyzed the impact of
financial leverage and financial results in a developing world background using two Ordinary
Least Square models focused on panel data composed of 816 cases (48 companies × 17 years).
Corporate efficiency was calculated using return on asset, return on equity, earnings per share
and Tobin's Q and financial risk was measured using debt-asset and debt-equity ratios. The result
identified that return on asset and Tobin's Q was negatively associated with financial leverage,
which is compatible with the pecking order theory, market timing theory and other observational
studies.

The greater the profits made by a firm, the greater its stability and ability to handle meeting
financial obligations arising from debt. This imposes that profit earning firms are more likely to
add more debt in their capital structure compared to firms making losses thereby suggesting that
financial performance is key in making financial leverage decisions.

Desta (2020) analyzed the influence of financial leverage on financial performance of 5

Ethiopian Commercial Banks for a period of 10 years (2008-2017). Debt ratio, debt-equity ratio
and interest coverage ratio were utilized in measuring financial leverage while return on asset
and return on equity ratios were used for financial performance. The ex-post facto and
25
longitudinal research design were used. Secondary data was collected from audited financial
reports and descriptive statistics and fixed effect model were used. The study showed that debt
ratio has a negative insignificant effect on bank's performance measured by return on asset and
return on equity while debt-equity and interest coverage ratio has a significantly positive effect
on bank's performance measured by return on assets and return on equity.

Another researcher Ahmadu (2015) analyzed the relationship between leverage and financial
performance of deposit banks in Nigeria with special respect to how debt-equity ratio and debt
ratio impact the equity of deposit money banks in Nigeria. The study used a sample of 11 banks
with deposit money from the bank's hierarchy Tier 1-3 using convenience sampling technique for
the period ranging 2005-2013. The research followed both analytical and correlation analysis.
Findings from the correlation study showed that the relationship between debt-equity ratio and
financial performance proxy by return on equity persists substantially. But, it also imposed that
there is no significant relationship between debt ratio and return on equity surrogated financial
efficiency. The analytical study revealed the total number of deposit money banks reserves in
Nigeria that are debt-financed is at least 84%. This suggests that banks are heavily leverage
institutions. Amongst others, this study advised that banks should follow an acceptable debt-
equity balance if they wish to boost up their financial performance, succeed and stay
competitive.

2.3 Theoretical Review

2.3.1 Pecking order theory

26
The pecking order theory is a theory in finance that explains the financing decisions made by
firms. Developed by Myers and Majluf in 1984, the theory suggests that firms have a preferred
hierarchy of financing sources, with internal funds (retained earnings) being the most preferred,
followed by debt, and then external equity. This theory helps explain why companies tend to
avoid the issuance of new equity when they need to raise additional capital. According to Myers
(1984), the pecking order theory revolves around the signaling effect of stock prices. Firms with
overvalued shares tend to issue equity, while those with undervalued shares opt to issue debt to
avoid the dilution effect. This theory assumes information asymmetry and implies that managers
possess more knowledge about their firm's intrinsic value than external investors.

The first choice for financing new investments according to the pecking order theory is retained
earnings. This source of financing involves utilizing profits that are not paid out as dividends and
reinvesting them back into the business. These earnings are considered the least costly and least
asymmetric information source of financing (Myers, 1984). By using retained earnings, firms
reduce the agency costs associated with external funding.

When retained earnings are insufficient, firms turn to debt financing. Debt can be acquired
through various sources, such as bank loans or issuing corporate bonds. According to the pecking
order theory, debt financing is preferred over equity financing because it is less likely to signal
negative information to the market. Myers (1984) argues that firms choose debt because they
have less information asymmetry than outside investors, making it less likely that issuing debt
will raise concerns about the firm's quality.

External equity is the least preferred method of financing according to the pecking order theory.
It involves issuing new shares of stock to raise capital. The theory suggests that the issuance of
new equity sends a negative signal to the market, as it implies that the company cannot finance
its investments through retained earnings or debt issuance (Myers, 1984). The negative signal
can result in a decrease in the firm's stock price due to adverse selection and moral hazard
problems.

The pecking order theory is empirically supported by several studies. Myers and Majluf (1984)
provide evidence that companies tend to finance investment primarily through internal sources
before resorting to external financing. Chen and Chen (2011) also find support for the pecking
order theory in their study of Taiwanese firms, concluding that firms in their sample rely more
on internal funds and short-term debt than equity issuance. Graham and Harvey (2001)
conducted a cross-sectional analysis of 3,167 firms and found evidence that firms tend to follow
the pecking order in their financing decisions. Chen and Zhao (2006) analyzed Chinese listed
companies between 1998 and 2002 and found that retained earnings played a significant role in
financing investment projects.

27
However, some studies challenge the pecking order theory. Shyam-Sunder and Myers (1999)
argue that agency costs and financing hierarchy are endogenous and may not be solely driven by
the pecking order theory. They find that firms with high growth opportunities prefer using equity
financing even when internal funds are available. Furthermore, Rajan and Zingales (1995)
question the theory's generalizability by highlighting that external equity issuance is more
prevalent in countries with stronger legal systems and better-developed financial markets.

While the POT has gained popularity, critics argue that it oversimplifies capital structure
decisions (Frank and Goyal, 2003). Welch (2004), for instance, contests that the theory does not
account for the costs and benefits associated with different financing options. These criticisms
highlight the need for a comprehensive assessment of alternative theories.

Despite criticisms, the Pecking Order Theory has proved valuable in explaining certain patterns
of financing behavior. However, it should not be considered in isolation, as capital structure
decisions are influenced by various factors. Combining insights from the POT, the Trade-Off
Theory, and the Agency Cost Theory can provide a more comprehensive understanding of
corporate financing choices.

2.3.2 Modigliani-Miller (MM) theory of capital structure irrelevance

The Modigliani-Miller (MM) theory, developed by Franco Modigliani and Merton Miller in the
1950s, revolutionized the field of capital structure and corporate finance. This theory argues that
in a perfect and frictionless market, the value of a firm is unaffected by its capital structure. In
other words, the theory suggests that the way a firm finances its investments, whether through
debt or equity, does not impact its total market value.

The core idea behind the MM theory is the concept of arbitrage. Modigliani and Miller argued
that in perfect markets, rational investors would be able to exchange securities at fair prices
without incurring any costs. This means that any opportunities for arbitrage would quickly be
exploited, causing the market to adjust and eliminate potential gains. Based on this assumption,
the MM theory concludes that the value of a firm is independent of its capital structure.

One of the main implications of the MM theory is the irrelevance of capital structure on firm
value. This implies that a firm's financial decisions, such as issuing debt or equity, do not impact
the overall value of the firm. According to Modigliani and Miller, if a firm increases its debt and
reduces its equity, the cost of equity will increase proportionally to maintain the same overall
cost of capital. This compensates investors for the increased risk associated with higher leverage,
resulting in unchanged firm value.

The MM theory also addresses the issue of taxes. Modigliani and Miller recognized that in the
real world, corporate taxes exist and can affect the value of a firm. They found that, while taxes
can create differences in the cost of debt and equity, these effects are offset by corresponding
28
changes in the value of the firm. Therefore, the MM theory suggests that the impact of taxes on
capital structure decisions is largely neutralized at the firm level.

However, it is essential to note that the MM theory only holds true under a set of assumptions
that are not entirely realistic in the real world. Some of these assumptions include perfect
markets, no taxes on personal income, no costs of financial distress, no agency costs, and
symmetric access to information. In reality, these assumptions do not hold, and they have been
extensively criticized by researchers in subsequent years.

Critics argue that the MM theory is limited in its applicability due to the numerous real-world
frictions and imperfections that impact capital structure decisions. Factors such as bankruptcy
costs, tax advantages of debt, agency costs, and market signaling effects can all influence a firm's
capital structure choices and impact its value. These criticisms led to the development of various
extensions and refinements to the MM theory, such as the trade-off theory, pecking order theory,
and signaling theory.

Michael C. Jensen and William H. Meckling (1976) argued that the Modigliani-Miller theorem
had limitations due to factors such as agency costs and information asymmetry. They believed
that in the real world, capital structure decisions can impact a firm's value. Stewart C. Myers
(1984) developed the pecking order theory as a critique of the Modigliani-Miller theorem. He
proposed that firms prefer internal financing over external financing, as external financing tends
to be costlier due to asymmetric information.

The Modigliani-Miller theory, with its core premise of capital structure irrelevance, has been
influential in shaping modern corporate finance. While its assumptions may not fully reflect
reality, it provides a crucial benchmark for understanding the impact of capital structure
decisions on firm value. Researchers continue to build upon the MM theory, incorporating real-
world complexities to develop more comprehensive frameworks for analyzing capital structure
choices.

2.3.3 Net operating income theory

The net operating income (NOI) theory of capital structure examines the relationship between a
company's debt-equity mix and its net operating income. This theory suggests that the optimal
capital structure can be determined based on maximizing the firm's net operating income. The
theory implies that companies can enhance their overall value by judiciously managing their
borrowing proportion.

The NOI theory of capital structure originated from the pioneering work of Franco Modigliani
and Merton Miller in the 1950s. They developed the theory of capital structure irrelevance,
asserting that in perfect capital markets, the firm's value remains unaffected by its capital
structure decisions. However, later researchers, such as Kraus and Litzenberger (1973),
29
introduced the NOI theory as a modification, stating that the operational income does play a
significant role in optimizing the firm's value.

According to the NOI theory, an optimal capital structure can enhance the overall value of a
firm. This occurs when the company has reached an equilibrium between the tax advantages
provided by debt financing and the related risks. The analysis of different capital structures
guides the firm to determine the level of debt that maximizes the net operating income and
consequently the firm's value (Titman and Wessels, 1988).

Despite its fundamental role in the early development of capital structure theories, the net-
income theory has attracted criticism from academics and practitioners for several reasons: The
NOI theory assumes perfect capital markets with no costs or imperfections. However, in reality,
various market imperfections, such as information asymmetry, agency costs, and transaction
costs, can significantly impact capital structure decisions. The generalizability of the NOI theory
across different industries is also questioned as industries with stable earnings may benefit more
from debt financing, while industries with uncertain cash flows may require a lower debt-equity
ratio. Some researchers argue that the NOI theory only suggests a suboptimal capital structure
that can maximize operating income, not necessarily the firm's overall value (Myers, 1984).

Numerous empirical studies have examined the validity of the NOI theory, offering mixed
results. Some studies, like those by Rajan and Zingales (1995), found support for the theory,
Graham and Harvey (2001) found that in a sample of over 8,000 US firms, many firms displayed
a preference for a debt level corresponding to their maximum tax shield, implying support for the
existence of an optimal capital structure. Other studies such as Huang and Ritter (2009), found
inconsistencies. Modigliani and Miller (1963) challenged the assumptions of the net-income
theory by introducing the concept of tax advantages of debt. Their study found that including tax
benefits significantly altered the optimal capital structure, suggesting that tax considerations
must be incorporated into the analysis. These studies highlight the complexities associated with
capital structure decisions and the need for incorporating industry-specific factors.

The net operating income theory of capital structure continues to be a valuable framework for
evaluating a firm's debt-equity mix. While it provides insights into the relationship between
operating income and capital structure, its practical applications in real-world scenarios continue
to be debated. However, by considering the trade-off between tax benefits and risks, businesses
can leverage the theory to make more informed capital structure decisions, taking into account
industry-specific characteristics.

2.3.4 Trade-off theory

The trade-off theory posits that companies aim to strike a balance between the tax advantages
associated with debt and the costs of financial distress (Myers, 1984). Debt allows firms to

30
benefit from interest tax shields, while an excessive debt burden may increase the risk of
financial distress, potentially leading to bankruptcy.

The theory suggests that as a firm takes on more debt, the costs of financial distress rise due to
higher interest payments and increased probability of default. Thus, there exists an optimal level
of debt that maximizes firm value. Companies should weigh the benefits of tax shields against
the costs of financial distress when determining their capital structure (Myers, 1984).

Trade-off theory is a fundamental concept in economics and finance that examines the
relationship between risk and return when making financial decisions. It highlights the trade-offs
that individuals, firms, and investors face when choosing between different investment options or
financing choices.

In essence, the trade-off theory posits that higher returns come with higher levels of risk. This
means that as investors seek to maximize their returns, they must accept and manage a certain
level of risk. The trade-off theory suggests that individuals or firms must strike a balance
between these two factors to make optimal decisions.

One of the main trade-offs examined by the trade-off theory is the choice between debt and
equity financing for firms. Debt financing involves raising funds by borrowing money from
external sources like banks or bondholders, while equity financing involves raising funds by
selling ownership shares in the firm to investors. Each option has its advantages and
disadvantages, and the trade-off theory helps firms determine the optimal mix of debt and equity
financing.

Stewart C. Myers (1984) argues that the trade-off theory is a rational choice framework, where
firms make a trade-off between the benefits and costs of debt financing. He emphasizes that debt
provides tax shields but increases financial distress costs. Eugene F. Fama (1985) supports the
trade-off theory by asserting that debt can be an optimal choice for firms as long as the tax
advantage of debt outweighs the costs of bankruptcy and financial distress. Another researcher
who supports the trade-off theory is Michael C. Jensen (1986) who suggests that managers have
an incentive to exploit the tax advantages of debt to increase shareholder value.

Franklin Allen and Douglas Gale (1999) argue that the trade-off theory can explain variations in
firms' capital structures based on differences in their investment opportunities and risks. Tim
Opler and Sheridan Titman (1994) is of the view that factors like growth opportunities,
profitability, and asset tangibility affect the optimal capital structure based on the trade-off
theory.

These scholars and researchers have provided various opinions and insights into the trade-off
theory, highlighting the benefits and costs associated with debt financing decisions for firms.

31
Overall, the trade-off theory helps inform decisions in finance and economics by highlighting the
necessary trade-offs between risk and return, as well as between different financing options. It
provides a framework for individuals, firms, and investors to make informed choices that align
with their specific circumstances, risk preferences, and financial objectives. By understanding
these trade-offs, individuals and organizations can better navigate the complex world of finance
and optimize their decision-making processes.

3. METHODOLOGY
32
3.1. Research Design

This study used an experimental research design, often known as a "causal research design." In
such investigations, the researcher is confronted with "cause-and-effect" issues, with the
separation of such factors being the primary objective. Because the ultimate goal of the study is
to investigate how financial leverage influences company performance in the consumer goods
sector, the explanatory study was deemed most appropriate for our topic of study.

3.2. Population and Sampling

The population is composed of the twenty-one (21) consumer goods companies that are publicly
traded on the Nigerian Stock Exchange. The sample was chosen on the basis of the accessibility
of yearly reports from 2018 to 2022. Hence, the sample size comprised thirteen (13) firms,
capturing sixty-two percent (62%) of the overall population.

The rationale behind the 5-year time range is to give a more recent insight into the impact of
financial leverage on financial performance.

3.3. Sources of Data

The majority of the information for this study came from secondary sources. Secondary data
underlying this study were extracted from yearly reports published on the Nigerian Stock
Exchange website.

3.4. Model Specification

An exogenous (independent) latent variable and one endogenous (dependent) latent variable
feature in the theoretical model (original model). Three observable variables reflect the external
latent variable, which is a leverage specific variable. The debt-equity ratio, asset-equity ratio, and
degree of financial leverage are all part of the leverage specific latent variable.

The endogenous latent variables are firm performance specific features that are mirrored by the
observed variables: return on equity, return on asset, and earnings per share. The rationale behind
this is based on the paper published by John Dearden, William F. Meek, and Michael C. Ohlson
titled "Accounting-Based Measures of Corporate Performance: A Simulation" in 2000. They
argue that financial measures, such as earnings per share, return on equity, and return on assets,
are crucial indicators of firm performance and should be carefully examined by investors.

3.5. Method of Data Analysis

33
To investigate the causal links and test the hypotheses between the observable and latent
constructs in the proposed research model, a structural equation modeling (SEM) approach based
on AMOS 26.0.0 is used. SEM has two sub-models: a measuring model and a structural model.
While the measurement model defines relationships between observed and unobserved variables,
the structural model identifies relationships within unobserved/latent variables by identifying
which latent variables impact alterations in other latent variables in the model directly or
indirectly (Byrne, 2001; Hair et al., 2010). In addition, the structural equation modeling process
was divided into two steps: validating the measurement model and fitting the structural model.
The former was achieved by confirmatory factor analysis, whereas the latter was achieved
through route analysis with latent variables (Kline, 2005). Using a two-step approach ensures
that only constructs from the data collection with good measurements (validity and reliability)
are incorporated in the structural model (Hair et al., 2010).

3.6. Operationalization of Variables

34
 Variables Measurements Symbols Category Source

Return on Net income/average ROA Endogenous Nigeria

assets total assets variable Stock
Exchange
website

Return on (Net income/ ROE Endogenous Nigeria

equity shareholder's equity) × variable Stock
100 Exchange
website

Earnings per Net EPS Endogenous Nigeria

share earnings/outstanding variable Stock
shares Exchange
website

Debt-equity Total debt/shareholder's DER Exogenous Nigeria

ratio equity variable Stock
Exchange
website

Asset-equity total AER Exogenous Nigeria

ratio assets/shareholder's variable Stock
equity Exchange
website

Degree of % change in EPS/% DFL Exogenous Nigeria

financial change in EBIT variable Stock
leverage Exchange
website

4. DATA REPRESENTATION AND ANALYSIS

A structural equation model (SEM) generated through Amos 26.0.0 was used to test the
relationships. The results were as follows:

C:\Users\T-WHYTE\Desktop\Ace Folder\RESULTS\tpj.amw

Analysis Summary

Date and Time

35
Date: Monday, 2 October 2023

Time: 4:09:53 am

Title

tpj: Monday, 2 October 2023 4:09 am

Groups

Group number 1 (Group number 1)

Notes for Group (Group number 1)

The model is recursive.

Sample size = 65

Variable Summary (Group number 1)

Your model contains the following variables (Group number 1)

Observed, endogenous variables

EPS

ROA

ROE

AER

DER

DFL

Unobserved, endogenous variables

fp

Unobserved, exogenous variables

e1

e2

36
e3

fl

e4

e5

e6

e7

Variable counts (Group number 1)

Number of variables in your model: 15

Number of observed variables: 6

Number of unobserved variables: 9

Number of exogenous variables: 8

Number of endogenous variables: 7

4.1. Model Fit

Model Fit Summary

CMIN

NPA CMIN/
Model CMIN DF P
R DF

Default model 13 8.663 8 .372 1.083

Saturated model 21 .000 0

Independence model 6 50.644 15 .000 3.376

RMR, GFI
37
Model RMR GFI AGFI PGFI

Default model 20.927 .941 .844 .358

Saturated model .000 1.000

Independence model 43.212 .652 .513 .466

Baseline Comparisons

NFI RFI IFI TLI

Model CFI
Delta1 rho1 Delta2 rho2

Default model .829 .679 .984 .965 .981

Saturated model 1.000 1.000 1.000

Independence model .000 .000 .000 .000 .000

Parsimony-Adjusted Measures

PRATI
Model PNFI PCFI
O

Default model .533 .44 .52

Saturated model .000 .00 .00

Independence model 1.000 .00 .00

NCP

Model NCP LO 90 HI 90

Default model .663 .000 12.114

Saturated model .000 .000 .000

Independence model 35.644 17.720 61.163

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FMIN

Model FMIN F0 LO 90 HI 90

Default model .14 .01 .00 .19

Saturated model .00 .00 .00 .00

Independence model .79 .56 .28 .96

RMSEA

RMSE PCLOS
Model LO 90 HI 90
A E

Default model .036 .00 .15 .489

Independence model .193 .14 .25 .000

AIC

Model AIC BCC BIC CAIC

Default model 34.663 37.856 62.930 75.930

Saturated model 42.000 47.158 87.662 108.662

Independence model 62.644 64.118 75.691 81.691

ECVI

Model ECVI LO 90 HI 90 MECVI

Default model .542 .531 .721 .591

Saturated model .656 .656 .656 .737

Independence model .979 .699 1.378 1.002

HOELTER

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 HOELTE HOELTE
Model R R
.05 .01

Default model 115 149

Independence model 32 39

Execution time summary

Minimization: .316

Miscellaneous: 1.682

Bootstrap: .000

Total: 1.998

Source: Researcher's Amos Computations

A good fitting model is accepted if the values of CMIN/df is < 5, the Goodness-of-fit (GFI)
indices > 0.90, the CFI and TLI both > 0.90 (Hair et al, 2010). In addition, an adequate fitting
model is accepted if the Amos computed values of the Root Mean Square Error Approximation
(RMSEA) is < 0.08. The fit indices shown above fell within the acceptable range with CMIN/df
= 1.083, GFI = 0.941, TLI = 0.965, CFI = 0.981, and RMSEA=0.036. This proves that the model
has a good fit.

4.2. Regression Analysis

Group number 1 (Group number 1 - Default model)

Estimates (Group number 1 - Default model)

Scalar Estimates (Group number 1 - Default model)

Asymptotically Distribution-free Estimates

Regression Weights: (Group number 1 - Default model)

Estimate S.E. C.R. P Label

fp <--- fl .540 .272 1.988 .047 par_4

40
 Estimate S.E. C.R. P Label

EPS <--- fp 1.000

ROA <--- fp .019 .005 3.890 *** par_1

ROE <--- fp .039 .007 5.397 *** par_2

AER <--- fl 1.000

DER <--- fl 1.001 .003 293.990 *** par_3

DFL <--- fl .015 .004 3.893 *** par_5

Standardized Regression Weights: (Group number 1 - Default model)

Estimate

fp <--- fl .363

EPS <--- fp .854

ROA <--- fp .567

ROE <--- fp 1.273

AER <--- fl .999

DER <--- fl 1.001

DFL <--- fl .120

Variances: (Group number 1 - Default model)

Estimate S.E. C.R. P Label

fl 36.001 10.821 3.327 *** par_6

e6 69.076 33.007 2.093 .036 par_7

e1 29.426 16.478 1.786 .074 par_8

41
 Estimate S.E. C.R. P Label

e2 .060 .014 4.288 *** par_9

e3 .047 .016 2.872 .004 par_10

e4 .044 .100 .440 .660 par_11

e5 .038 .102 .373 .709 par_12

e7 .562 .203 2.766 .006 par_13

Squared Multiple Correlations: (Group number 1 - Default model)

Estimate

fp .652

DFL .014

DER 1.001

AER .999

ROE 1.621

ROA .322

EPS .730

Source: Researcher's Amos Computations

The study accessed the impact of financial leverage on financial performance. A relationship is
said to be significant if the Critical Ratio (C.R) is > 1.96 and Probability value (P value) < 0.05
(Kline, 2005). From the values gotten from the analysis it can be seen that the impact of financial
leverage on financial performance is both positive and significant ( b = 0.540, C.R = 1.988,
P=0.047) thereby supporting H1 hypothesis.

42
With the regression estimate being 0.540, it indicates that when financial leverage goes up or
increases due to both direct and indirect effects by 1, financial performance goes up by 0.540.
The standardized regression weights on the other hand indicates that when financial leverage
goes up due to direct and indirect effects by 1, financial performance goes up by 0.363 standard
deviations. The squared multiple correlation was 0.652 for financial performance. This shows
that a 65% variance in financial performance is accounted for by financial leverage while the
remaining 35% are contained in the error term that is variables not captured by this model.

Regarding the relationship between the observable variables (EPS, ROA, ROE, AER, DER DFL)
and their respective construct/latent variables (financial performance and financial leverage), the
analysis indicates that they are all positive and significant. The analysis indicates that when
financial performance increases by 1, EPS, ROA and ROE increases by 1, 0.19 and 0.39
respectively and when financial leverage increases by 1, AER, DER and DFL increases by 1,
1.001 and 0.015 respectively. Also, when financial performance increases by 1, EPS, ROA and
ROE increases by 0.854, 0.567 and 1.273 standard deviations respectively and when financial
leverage increases by 1, AER, DER and DFL increases by 0.999, 1.001 and 0.120 standard
deviations respectively.

Model Fit indices and hypothesis results are presented in the table below:

Hypothesized Standardized T-value P-value Decision

Relationship Estimates

FP <---- FL 0.540 1.988 0.047 Significant and

positive influence

R-Squared

FP 0.652

Model Fit

CMIN/df GFI TLI CFI RMSEA Decision

1.083 0.941 0.965 0.981 0.036 Good fit

5. SUMMARY OF FINDINGS, CONCLUSION AND RECOMMENDATION

43
This study focuses on evaluating the relationship between financial leverage and financial
performance of listed consumer goods firms in Nigeria. In order to achieve the started objective,
thirteen (13) listed firms were selected with the criteria being that they are fully functional and
have adequate and available data covering the period of 2018 - 2022 as the period of the study
which was obtained from selected firms annual report posted in the Nigeria Stock Exchange
website. Data obtained was analyzed using structural equation model (SEM) and this was done
through IBM SPSS for the data computation and Amos 26.0.0 for running the analysis.

Three (3) observable variables (EPS, ROA, ROE) were used to represent financial performance
while another the observable variables (DER, AER, DFL) were used to represent financial
leverage. The findings revealed that financial leverage has a positive and significant influence on
financial performance.

The study recommends that since the major aims of firms is to make profit, improve performance
and increase shareholder's wealth, the level of leverage should be maintained at an optimal level
since leverage incures high interest obligation from earnings which will invariably erode the
firms profit and reduce amount to be distributed to the shareholders in form of dividends. Proper
strategic management, analysis and planning should be conducted to ascertain the optimal capital
structure. In addition, firms are advised to increase the equity portion of their debt-equity ratio as
this will lead to greater performance.

This study was limited to finding the impact of financial leverage on financial performance of
listed consumer goods firm in Nigeria, as such, further studies should focus on other sectors such
as ICT, industrial sector, oil and gas, financial e.t.c. Additionally, other financial measurements
can be used for future research including the use of primary data as this study made use of only
secondary data.

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