THE EFFECT OF LEVERAGE ON PROFITABILITY OF QUOTED PHARMACEUTICAL FIRMS IN NIGERIA Abstract The purpose of this study was to examine the impact of financial leverage on the financial performance of the pharmaceutical companies listed in the NSE. The study analyzed the impact of financial leverage on profitability and liquidity management. A descriptive research design was used. The data was collected from the annual accounts of companies listed on the Nigeria Stock Exchange for a period of five years, from 2012 to 2016. Correlation and regression analysis were used to determine the impact of financial leverage on the financial performance of the selected companies. Profitability (ROA), dividend payment index (DPR) and liquidity management (QR) served as a proxy for financial performance, while the leverage ratio was used as a leverage measure. Data were presented in tables. The results of the study found that there was a strong negative correlation between profitability and financial leverage, since companies that depended more on debt had lower profits, while those that relied more on equity had higher profits. Another result of the study showed that there is a weak negative correlation between financial leverage and the dividend payment ratio. The results also showed that there was a weak negative correlation between liquidity management and financial performance. The study recommended that companies should rely on less expensive sources of financing to avoid depletion of repayment loans, increase shareholder value, allow shareholders to reinvest their earnings instead of demanding dividends, and that financial managers should match your loan needs with the available assets to ensure the effective use of corporate assets. CHAPTER ONE INTRODUCTION 1.1 Background of the Study The performance of a firm is primarily affected by a number of factors, one of the most important ones being its capital structure (Salman and Yazdanfar, 2012). Capital structure is one of the most noteworthy decisions made by a firm as it is concerned with the ascertaining the optimum capital structure for the firm (Chadha and Sharma, 2015). Capital structure integrates the firm\u2019s long term debt, specific short term debt, common equity and retained earnings, which are all essential in financing the firm\u2019s overall operations and growth (Hasan, Ahsan, Rahaman, and Alam, 2014). Quoting Weston and Brigham (1979), they define capital structure as \u201cthe permanent financing of the firm represented by long term debt, preferred stock and net worth\u201d. Capital structure primarily merges equity and long term debt but doesn\u2019t generally consider short term debt (Hasan, Ahsan, Rahaman and Alam, 2014). Chadha and Sharma (2015) note that the capital structure is a continuous decision making process that is essential when a firm needs funds for its projects. They add that capital structure can only reach its optimum point when it boosts the firm\u2019s market value. Adding to that, Hasan, Ahsan, Rahaman and Alam (2014), suggest that an optimal capital structure is one that maximizes the value of the firm while reducing the cost of capital, thereby balancing the firm\u2019s risk and return. The challenge is that it is still impossible to ascertain a specific approach for determining the firm\u2019s optimal capital structure (Chadha and Sharma, 2015). The study of capital structure has been of interest to financial economists after Modigliani and Miller\u2019s irrelevance theory of capital structure in 1958 (Hasan et al., 2014). According to this theory, Modigliani and Miller argue that under perfect market conditions, a firm\u2019s capital structure has no impact on its value. However, this theory was challenged by many researchers on grounds that there are no perfect markets in reality (Hasan et al., 2014). MM later revised their earlier theory to include tax benefits, arguing that under imperfect market conditions where interest payments are tax deductible, a firm\u2019s value increases with the increase in financial leverage (Modigliani and Miller, 1963). Chadha and Sharma (2015) define financial leverage as \u201cthe ratio of debt and equity, which states the relationship between borrowed funds and owner\u2019s funds in the capital structure of the firm\u201d. They define that firms that rely on only equity are referred to as unlevered firms while those that rely on both debt and equity are referred to as levered firms. Financial leverage is a measure of how much firms use equity and debt to finance their assets (Enekwe, Agu, & Eziedo, 2014). Financial leverage has also been defined as the degree to which a company uses fixed income securities such as debt and preferred equity (Rajkumar, 2014). He adds that the higher the financial leverage, the higher the interest payments leading to low earnings per share. Previous studies about whether there is a relationship between financial leverage and the financial performance of a firm have been inconclusive. In his study, Rajkumar (2014), concluded that though there was a negative relationship between financial leverage and the financial performance of a firm, 54.8% of a firm\u2019s financial performance was affected by its financial leverage, attributing the remaining 45.2% to other factors. In their study, Innocent et al. (2014), concluded that the debt to equity ratio has a negative relationship with the firm\u2019s return of assets while the interest coverage ratio of financial leverage has a positive relationship with the return on assets. Salim and Yadav (2012) concluded that total debt has a weak positive relationship with a firm\u2019s financial performance measured by earnings per share. The global financial crisis affected the capital structures of a number of firms globally, especially the highly levered firms despite the difference in the magnitude of the impact due to differences in financial market development and other factors (Zarebski and Dimovski, 2012). They explain that during the economic boom, most firms were highly liquid, leading to high rates of lending, refinancing and underwriting by financial institutions. This was halted by the real estate market crash in the US which led to the loss of value of many assets, leading to the highly levered firms to default their debts (Zarebski and Dimovski, 2012). The impact of financial leverage on the value of firms varies across countries due to the difference in tax laws and tax brackets (Obradovich and Gill, 2012). Their study concluded that the value of American firms was positively impacted by financial leverage, among other factors. In their study, Cole, Yan and Hemley (2015), showed that taking on more debt had a negative impact on the ROA and operating return of firms in the healthcare sector. The same study indicated that there was no impact on the profit margins of healthcare firms from taking on more debt. Cole, Yan and Hemley (2015) also found that taking on more debt negatively impact the ROA, operating return and profit margin of US firms in the energy sector. However, their study showed that financial leverage had no impact on the firms\u2019 stock prices. Chadha and Sharma (2015) found that higher debt results into low ROE for shareholders. Mireku, Mensah and Ogoe (2014) found that a higher percentage of Ghanaian companies preferred shortterm debt to long-term debt as a source of funds to finance their assets and operations. They attribute this to the inaccessibility to long term debt due to the high lending rates offered by banks and the immaturity of the Ghanaian capital market. Ojo (2012) shows that financial leverage has a significant negative effect on the performance of firms in Nigeria. He however adds that firms are likely to opt for more debt financing in case of poor performance. Enekwe et al. (2014) on the other hand concludes that financial leverage has no significant impact on the performance of pharmaceutical firms in Nigeria. Adesina, Nwidobie and Adesin (2015) suggest that management of quoted banks in Nigeria consistently use debt and equity as a way of improving earnings, an indication of a significant relationship between capital structure and financial performance of firms. South African firms are characterized by ownership structures that display a top down chain of command, where the owner of the firm is at the top of the pyramid (Fosu, 2013). He adds that this kind of structure distinguishes the kind of agency problems faced by South African firms from those of other countries because they exist between minority and majority shareholders. This top down structure primarily depends on equity as a source of funds and debt contracts may only be adopted as a measure of mitigating the agency problem (Fosu, 2013) His findings suggest that financial leverage has a significantly positive effect on firm performance, which is enhanced by the compaction in product markets. This contradicts the earlier findings of Abor (2007), who found a significant negative impact of financial leverage on the performance of a firm. Githira and Nasieku (2015) show a negative relationship between financial leverage and the growth of East African Companies, adding that companies need to boost their operations and maximize profits so as to avoid relying on debt. Their research also showed that increase in financial leverage reduces the firms cost of capital, as argued by Modigliani and Miller (MM, 1958). 1.2 Statement of the Problem One of the significant roles of a financial manager of a firm is the formulation of financial policies that are intended to maximize the profitability of the firm, among them being the capital structure or leverage decision (Mueni and Muturi, 2015). They add that these decisions have an effect the company\u2019s retained earnings, which in turn influences the company\u2019s future growth, investment potential and working capital. Therefore, it is important for firms in developing countries to find optimum levels of their capital structure so as to fund their activities and grow enough to generate income and employment opportunities (Wachilonga, 2013). However, due a limited availability of company resources, finance managers have to work hard to ensure proper working capital management so as to avoid the opportunity cost of foregoing the resources held in current assets, hence lowering the firm\u2019s returns (Mueni and Muturi, 2015). A firm\u2019s capital structure generally consists of debt and equity and the choice between the two is significant to a firm (Musina, Ngala, and Okaka, 2015). All in all, a firm\u2019s financial leverage choices are explained by a number of theories (Mule and Mukras, 2015). According to Mule and Mukras (2015), the trade-off theory underlies the fact that the use of leverage in a firm\u2019s capital structure is beneficial up to the point where the optimum capital structure, which is determined by the trade-off between the bankruptcy costs and the tax benefits of borrowing (Owolabi and Inyang, 2013). The Pecking order theory explains that firms\u2019 preference for different finance sources is based on the ease of accessibility and the associated costs (Myers and Majluf, 1984), adding that debt is considered less expensive and more flexible (Mule and Mukras, 2015). The MM theory underlies the assumption that in a perfect market with no transaction costs, taxes and bankruptcy costs, the capital structure of a firm is irrelevant to its value and that what matters is the ability of the firm\u2019s assets to generate earnings (MM, 1958). A number of empirical studies have been carried out about the effect of financial leverage on the financial performance of firms in Kenya. Mueni and Muturi (2015) found that there was a significant negative relationship between financial leverage and the performance of sampled NSE listed firms. This is in support of the findings of (Mule and Mukras, 2015). However, Maniagi, Mwalati, Ondieki, Musiega and Ruto (2013), reported both positive and negative relationships between financial leverage and firm performance. Therefore, the debate of whether financial leverage has an effect on the performance of a firm has been inconclusive. Because a number of these studies have examined the relationship between financial leverage and financial performance of financial institutions, this study will examine the effect of financial leverage on the financial performance of Nigeria pharmaceutical companies 1.3 Objective of the Study The purpose of this is to analyze the effect of financial leverage on the financial performance of a firm. Specifically this study aims: 1.4 Research Questions 1 What is the effect of financial leverage on profitability? 2 What is the effect of financial leverage on dividend policy? 3 What is the effect of financial leverage on liquidity Management? 1.5 Significance of the Study Shareholders This study will provide shareholders with measures of evaluating the most favorable level of debt and equity to employ so as to avoid agency costs and achieve their objective of maximizing wealth. Finance Managers The study will provide guidance for finance managers to drafting and implementing financial policies that will expand their companies profit potential. Policy Makers The research will help policy makers in reviewing and reformulating better monetary policies and reforms so as to make funds more readily available and accessible for firms. Researchers: This research will guide researchers to investigate the extent to which financial leverage negatively or positively influences the firm\u2019s performance and which other factors are at play. 1.6 Scope of the study The study analyzed data from financial statements of non-financial firms listed on the Nigeria Stock Exchange. 1.7 Definition of Terms Debt : This refers to borrowed funds in the capital structure (Chadha and Sharma, 2015). Equity : This refers to the owners\u2019 capital in the capital structure (Chadha and Sharma, 2015). Optimal Capital Structure : The level of financial leverage at which the benefits and costs of debt financing are exactly balanced (Mule and Mukras, 2015). Tax Deductible : Taken away from the total amount of income you pay tax on (Cambridge Dictionary, retrieved on 26th January, 2017).