Impact Of Capital Structure On The Profitability Of Quoted Insurance Companies In Nigeria

Table of Contents

CHAPTER ONE
INTRODUCTION
1.1 Background to the Study
1.2 Statement of the Problem
1.3 Statement of the Research Questions
1.4 Objectives of the Study
1.5 Statement of the Hypotheses
1.6 Significance of the Study
1.7 Scope of the study
1.8 Limitations of the study
1.9 Operational Definition of Terms

CHAPTER TWO
LITERATURE REVIEW
2.1 Introduction
2.2 Concept of Profitability
2.3 Concept of Capital Structure
2.4 Review of Literature on Previous Studies
2.5 Theoretical Framework
2.6 Knowledge Gap

CHAPTER THREE
RESEARCH METHODOLOGY
3.1 Introduction
3.2 Research Design
3.3 Population of the Study
3.4 Sources of Data
3.5 Method of Data Collection
3.6 Sample Size
3.7 Sampling Technique
3.8 Variable Measurement
3.9 Model Specification
3.10 Techniques for Data Analysis
3.11 Justification of Methods Used

CHAPTER FOUR
DATA PRESENTATION AND ANALYSIS
4.1 Introduction
4.2 Data Presentation and Analysis
4.3 Test of Hypotheses
4.4 Discussion of Findings

CHAPTER FIVE
SUMMARY, CONCLUSION AND RECOMMENDATIONS
5.1 Summary
5.2 Conclusions
5.3 Recommendations
5.4 Contribution to Knowledge
5.5 Recommendations for Further Studies

Reference

CHAPTER ONE

INTRODUCTION

1.1 Background to the Study

Financing and investment are two major decision areas in companies. In the financing decision the manager is concerned with determining the best financing mix or capital structure for the insurance firm. Capital structure decision is the mix of debt and equity that insurance company uses to finance its business (Abubakar, 2016). Capital structure has been a major issue in financial economics.

Capital structure is one of the finance topics among the studies of researchers and scholars. Its importance derives from the fact that capital structure is tightly related to the ability of insurance firms to fulfil the needs of various stakeholders. Capital structure represents the major claims to insurance company assets. Research on the theory of capital structure was pioneered by the seminal work of Addae (2015). Significant empirical and theoretical extensions followed and the broad consensus paradigm, at least until recently, is that insurance firms choose an appropriate (optimal) level of debt, based on a tradeoff between benefits and cost of debt (Ahmad and Aris, 2019). It has also been argued that profitable insurance firms were less likely to depend on debt in the capital structure than less profitable ones and that insurance firms with high growth rates have high debt to equity ratios (see Akinyomi and Olagunju, 2016). There is no doubt that benefits abound in the use of debt in the capital structure of the insurance firms. The main benefit of debt financing is the tax-deductibility of interest charges, which results in lower cost of capital (Nyarko-Baasiand Hughes, 2013).

In practice, insurance firms differ from one another in respect of size, nature, earnings, cost of funds, competitive conditions, market expectations and risk. Therefore, the theories of capital structure may provide only a broad theoretical framework for analyzing the relationship between leverage and cost of capital and value of the insurance firm (Elgiziry, 2015). A financial manager however, should go beyond these considerations as no empirical model may be able to incorporate all these subjective features. There are in fact, a whole lot of factors, qualitative, quantitative and subjective, which should be considered and factored in the process of planning and designing a capital structure for an insurance firm. Besides, these considerations, care should be taken to ensure that the capital structure is evaluated in its totality and a finance manager should find out as to which capital structure is most advantageous to the insurance firm. The insurance firm should also suitably take care of the interest of the shareholders, debt holders and management. Above all, the legal provisions (if any) regarding the capital structure should also be considered.

A list of factors relative to capital structure decisions such as profitability, growth of the insurance firm, size of the insurance firm, debt maturity, debt ratio, tax and tangibility have been identified; however, considerations affecting the capital structure decisions can be studied in the light of minimization of risk. An insurance firm's capital structure must be developed with an eye towards risk because it has a direct link with the value.

Capital structure is said to be efficient, if it keeps the total risk of the insurance firm to the minimum level. The long term solvency and financial risk of an insurance firm is usually assessed for a given capital structure. Since increase in debt financing affects the solvency as well as the financial risk of the insurance firm, the excessive use of debt financing is generally avoided. It may be noted that the balancing of both the financial and business risk is implied so that the total risk of the insurance firm is kept within desirable limits. An insurance firm having higher business risk usually keeps the financial risk to the minimum level; otherwise the insurance firm becomes a high-risk proposition resulting to higher cost of capital (Agyei, 2015)

After over half a century of studies on this great topic, economists and financial experts have not reached an agreement on how and to which extent insurance firms’ capital structure impacts the value of insurance firms, their performance and governance. However, the studies and empirical findings of the last decades have at least demonstrated that capital structure has more importance than was found with the pioneering Miller-Modigliani model. We might probably be far from the ideal combination between equity and debt, but the efforts of fifty years of studies have provided the evidence that capital structure does affect insurance firms’ value and future performance. This study is an attempt to contribute to the empirical studies on how capital structure affects insurance firm’s profitability.

1.2 Statement of the Problem

The difficulty facing insurance companies in Nigeria has to do more with the financing – whether to raise debt or equity capital. The issue of finance is so important that it has been identified as an immediate reason for business failing to start in the first place or to progress. Thus it is necessary for insurance firms in Nigeria to be able to finance their activities and grow over time, if they are ever to play an increasing and predominant role in creating value added, as well as income in terms of profits. From the foregoing, it is therefore important to understand how capital structure affects their profitability (Alvas, 2018).

Previous studies regarding the effect of capital structure on the insurance firm profitability has been widely applied to the various sectors with varying research results. Research conducted by (Yegon 2016, Wahab, 2017 &Mimalthasan 2015), find that capital structure has positive effect on the insurance firm profitability. On the other hand, research conducted by (Velnampy & Poudel 2013; Thapa & Gurung 2016) found the opposite result, that the capital structure has negative effect on the performance of the firm. Ramli (2014) study also found that the capital structure has a weak-no effect on the performance of the firm. Moreover, there are onlyfew studies have been done related to the capital structure, especially in the financial sector of Nigeria. From previous studies regarding the capital structure, there is a difference in the results obtained, that the capital structure can effect positively, negatively or even no effect on the firm’s performance. Previous study on the financial sector mostly only focus on banking subsector, while other subsectors in the financial sector (i.e. insurance companies) excluded from the sample.

Previous studies on psychological contract does not separate dimension of capital structure, they combine equity share capital, preference share capital, retained earnings and long term loans into one element which does not give a detail explanation of the various dimension of the capital structure (Cheruiyot, 2014). It is against this background that the researcher studies capital structure and profitability of Nigerian quoted insurance companies.

1.3 Statement of the Research Questions

Based on the statement of the problems formulated above, the following research questions are asked:

i. What impact has equity share capital on the profitability of Nigeria Quoted insurance companies?
ii. What effect has preference share capital on the profitability of Nigeria Quoted insurance companies?
iii. What is the impact of retained earnings on the profitability of Nigeria Quoted insurance companies?
iv. What is the impact of long term loans on the profitability of Nigeria Quoted insurance companies?

1.4 Objectives of the Study

The main objective of the study is to examine the impact of capital structure on the profitability of Nigerian quoted insurance companies with special emphasis on AIICO.

Other specific objectives include:

i. To examine the impact of equity share capital on the profitability of Nigeria Quoted insurance companies.
ii. To determine the impact of preference share capital on the profitability of Nigeria Quoted insurance companies.
iii. To ascertain the impact of retained earnings on the profitability of Nigeria Quoted insurance companies.
iv. To examine the impact of long term loans on the profitability of Nigeria Quoted insurance companies.

1.5 Statement of the Hypotheses

The following hypotheses were stated in null form to guide the study:

H01 Equity share capital has no significant impact on the profitability of Nigeria Quoted insurance companies.

H02 Preference share capital has no significant impact on the profitability of Nigeria Quoted insurance companies.

H03 Retained earnings has no significant impact on the profitability of Nigeria Quoted insurance companies.

H04 Long term loan has no significant impact on the profitability of Nigeria Quoted insurance companies.

1.6 Significance of the Study

The study assists financial managers of firms to determine the proportion of equity capital and debt capital (capital structure) to obtain the debt financing mix that will optimize the value of the firm. This study, therefore, has contributed to the literature by examining capital structure and profitability of Nigerian quoted insurance companies. The study aids in the understanding of the impact of capital structure on insurance profitability. This has helped us to understand the impact of capital structure in profitability of Nigeria quoted insurance companies.

The outcome from this study will help decisions on capital structure and allow the policy makers in formulating informed policies on capital structure and also to measure the implications of such policies on the operations of quoted insurance companies. This will go a long way in helping investors in deciding whether to pull out their share in pursuance of capital gains or preserve their stake in a corporation. The study will contribute to existing body of knowledge by investigating capital structure and profitability of Nigerian quoted insurance companies. Also, stakeholders of insurance companies would be guided in making decision on capital structure. Lecturers, Students and researchers in finance will also benefit from this study. Finally, the research work will add to the existing literature on capital structure and profitability and compliment the work and contribution of other authors.

1.7 Scope of the study

The study examines the impact of capital structure on the profitability of Nigerian quoted insurance companies with specific emphasis on AIICO Plc which is one of the 15 quoted insurance companies in Nigeria. The scope covers the period of ten (10) years (2010 to 2020). AIICO PLC was selected based on the criteria of data availability.

This is because the data necessary for the study was not available in other Insurance companies within this period. The research work shed light on the concept of capital structure, concept of profitability and theories governing capital structure and review of literature on previous studies.

1.8 Limitations of the study

As no research is close to perfection, it is believed that some limitations exist and these could pave the way for further research over time. The first limitation of the study is that the research sample is restricted to the Nigerian quoted Insurance Companies Nigerian. Consequently, the study failed to extend its findings beyond the study population due to the limited sample i.e. quoted insurance companies. Thus the findings cannot be extended to other sectors of the economy. Therefore, the findings of this study are expected to be of help to the stakeholders of quoted insurance companies.

1.9 Operational Definition of Terms

Capital Structure: Capital structure represents the major claim to a corporation’s assets. This includes the different types of both equities and debt liabilities a firm employs in its business operations.

Optimal Capital Structure : This is the appropriate mix of equity and debt at which the value of a firm is maximized.

Long Term Debts : These are liabilities of a firm whose repayment exceed one year.

Short Term Debts : These are liabilities of a firm whose repayment is within a year.

Equity : Ownership interest in a corporation in the form of common stocks or preferred stocks. It can also be referred to as shares.

Leverage : This refers to the use of fixed charges source of funds such as debt, bond, and debenture capital along with the owners‟ equity in the capital structure. Leverage provides a good avenue of measuring risk. It could also be defined as a relative change in profit due to a change in sales. It can be further divided into operating leverage, financial leverage and combined leverage.

Risk : The possibility of suffering damage or loss in the face of uncertainty about the outcome of an action, future events or circumstances. It is the deviation of an actual outcome from the expected outcome in the presence of uncertainty.

Financial Risk : This is the increased risk of equity holders due to financial gearing. It is due solely to the capital structure of a firm or the level of gearing.

Business Risk : This is the variability in earnings before interest and tax (EBIT) associated with a company’s normal operation.

Weighted Average Cost of Capital (WACC) : This is the composite cost of capital representing the aggregate of the various sources of finance in use. It is used as a discount rate in the appraisal of new investment.

Corporate Income Tax: Corporate income tax is a tax based on the income made by a corporation. The corporation begins with Federal Taxable Income from the federal tax return. Corporate income tax is paid after the end of the taxable year based on the income made during the year. Company income subject to tax is often determined much like taxable income for individuals. Generally, the tax is imposed on taxable profits.

Corporate Performance Management: It entails reviewing overall business performance and determining how the business can better reach its goals. This requires the alignment of strategic.

CHAPTER TWO

LITERATURE REVIEW

2.1 Introduction

In chapter two, an attempt was made to review relevant and related literature on the topic. Previous research works, papers presented at seminars on the topic of discussion were reviewed in the chapter. The chapter gave a better picture of capital structure and profitability on Nigeria quoted insurance companies.

2.2 Concept of Profitability

Profitability means ability to make profit from all the business activities of an organization, company, firm, or an enterprise. It shows how efficiently the management can make profit by using all the resources available in the market (Percy, 2017). The word profitability is composed of two words, namely, profit and ability. The term profit has been explained above and the term ability indicates the power of a business entity to earn profits. The ability of a concern also denotes its earning power or operating performance. The profitability may be defined as the ability of a given investment to earn a return from its use. Profitability is a relative concept whereas profit is an absolute connotation (Tony and Philip, 2016). Despite being closely related to and mutually interdependent, profit and profitability are two different concepts. In other words, in spite of their generic nature, each one of them has a distinct role in business. As an absolute term, profit has no relevance to compare the efficiency of a business organization (Cheruiyot, 2014). Ben, (2016) opined that a very high profit does not always indicate sound organizational efficiency and low profitability is not always a sign of organizational sickness. Therefore, it can be said that profit is not the prime variable on the basis of which the operational efficiency and financial efficiency of an organization can be compared. To measure the productivity of capital employed and to measure operational efficiency, profitability analysis is considered as one of the best techniques.

Profit is an excess of revenues over associated expenses for an activity over a period of time. Lord Keynes remarked that ‘Profit is the engine that drives the business enterprise’. Every business should earn sufficient profits to survive and grow over a long period of time. It is the index to the economic progress, improved national income and rising standard of living (Uzma, 2018). Profit is the yardstick for judging not just the economic, but the managerial efficiency and social objectives also. Profitability means ability to make profit from all the business activities of an organization, company, firm, or an enterprise. It shows how efficiently the management can make profit by using all the resources available in the market. According to Ummara (2015) “profitability is the ‘the ability of a given investment to earn a return from its use.” However, the term ‘Profitability’ is not synonymous to the term ‘Efficiency’. Profitability is an index of efficiency; and is regarded as a measure of efficiency and management guide to greater efficiency. ‘Profit’ and ‘Profitability’ are used interchangeably. Profit refers to the total income earned by the enterprise during the specified period of time, while profitability refers to the operating efficiency of the enterprise. It is the ability of the enterprise to make profit on sales. It is the ability of enterprise to get sufficient return on the capital and employees used in the business operation. As Weston and Brigham rightly notes “to the financial management profit is the test of efficiency and a measure of control, to the owners a measure of the worth of their investment, to the creditors the margin of safety, to the government a measure of taxable capacity and a basis of legislative action and to the country profit is an index of economic progress, national income generated and the rise in the standard of living”, while profitability is an outcome of profit. In other words, no profit drives towards profitability. Firms having same amount of profit may vary in terms of profitability. That is why R. S. Kulshrestha has rightly stated, “Profit in two separate business concern may be identical, yet, many a times, it usually happens that their profitability varies when measured in terms of size of investment”. As manufacturing companies profitability is crucially important – as a main strategy for economic development – to any country adopting an export-oriented industrialization policy within an open economic environment. Sri Lanka has also made significant progress in its industrialization strategy through such a policy during the past three decades, it is important to examine how Sri Lankan manufacturing companies are performing when compared with their counterparts in a country that has achieved greater development in the manufacturing sector. Therefore, the purpose of this paper is to analysis the profitability of Sri Lankan manufacturing companies, measured in terms of company GP, NP, ROA, and the ROE – a country with a higher level of economic and industrial achievements in the past five decades. It is hoped that this study, while contributing to the literature, will also be useful to both economic planners and manufacturing companies in Sri Lanka. The paper is based on a study involving 10 selected manufacturing companies in Sri Lanka.

Profitability has been given considerable importance in the finance and accounting literatures. According to Uwuigbe, (2016), Profitability is one of the most important objectives of financial management since one goal of financial management is to maximize the owners’ wealth, and, profitability is very important determinant of performance. A business that is not profitable cannot survive. Conversely, a business that is highly profitable has the ability to reward its owners with a large return on their investment. Hence, the ultimate goal of a business entity is to earn profit in order to make sure the sustainability of the business in prevailing market conditions. Thagunna, (2018) defined the profitability as the ability of a business, whereas it interprets the term profit in relation to other elements. It is necessary to examine the determinants of profitability to understand how companies finance their operations. A financial benefit is realized when the amount of revenue gained from a business activity exceeds the expenses, costs and taxes needed to sustain the activity. Profitability analysis classifies measures and assesses the performance of the company in terms of the profits it earns either in relation to the shareholders’ investment or capital employed in the business or in relation to sales, profit, (or loss). Given that most entrepreneurs invest in order to make a return, the profit earned by a business can be used to measure the success of that investment (Ben, 2016). Amir (2018) defines that profitability is the organizations’ ability to generate income and its inability to generate income is a loss. He further asserts that if the income generated is greater than the input cost, that is simply profitability but if the incomes are less than the input cost, it reflects poor performance.

Amir, 2018 profitability is the primary goal of all business ventures. Without profitability the business will not survive in the long run. So measuring current and past profitability and projecting future profitability is very important. Profitability is measured with income and expenses. Income is money generated from the activities of the business (Mehdi, 2018). Expenses are the cost of resources used up or consumed by the activities of the business. Profitability is measured with an “income statement”. This is essentially a listing of income and expenses during a period of time (usually a year) for the entire business. Whether you are recording profitability for the past period or projecting profitability for the coming period, measuring profitability is the most important measure of the success of the business. A business that is not profitable cannot survive. Conversely, a business that is highly profitable has the ability to reward its owners with a large return on their investment (Rashmi, 2018).

2.3 Concept of Capital Structure

Capital structure of an insurance firm refers to the insurance company's outstanding debt and equity. It allows an insurance firm to understand what kind of funding the company uses to finance its overall activities and growth. In other words, it shows the proportions of senior debt, subordinated debt and equity (common or preferred) in the funding. Capital structure is essentially concerned with how the firm decides to divide its cash flows into two broad components, a fixed component that is earmarked to meet the obligations toward debt capital and a residual component that belongs to equity shareholders (Appiadjei, 2014).

The capital structure is how insurance firm finances its overall operations and growth by using different sources of funds. Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure (Mahmoud, 2014).

Capital structure of an insurance firm can be a mixture of a firm's long-term debt, short-term debt, common equity and preferred equity. An insurance company's proportion of short- and long-term debt is considered when analyzing capital structure. When analysts refer to capital structure, they are most likely referring to insurance firm's debt-to-equity (D/E) ratio, which provides insight into how risky a company is. Usually, a company that is heavily financed by debt has a more aggressive capital structure and therefore poses greater risk to investors. This risk, however, may be the primary source of the firm's growth (Anarfo, 2015).

Capital structure refers to a company’s outstanding debt and equity. It allows a firm to understand what kind of funding the company uses to finance its overall activities and growth. In other words, it shows the proportions of senior debt, subordinated debt and equity (common or preferred) in the funding. The purpose of capital structure is to provide an overview of the level of the company’s risk. As a rule of thumb, the higher the proportion of debt financing a company has, the higher its exposure to risk will be (Anju, 2018).

A company’s capital structure points out how its assets are financed. When a company finances its operations by opening up or increasing capital to an investor (preferred shares, common shares, or retained earnings), it avoids debt risk, thus reducing the potential that it will go bankrupt.

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