FINANCIAL LEVERAGE AND PERFOMANCE OF SMES IN KERICHO

TOWN: KERICHO COUNTY, KENYA

BY

BENARD

D53/CTY/PT/28210/2014

RESEARCH PROPOSAL SUBMITTED TO THE SCHOOL OF BUSINESS IN

PARTIAL FULFILMENT OF THE REQUIREMENTS FOR THE AWARD OF
THE DEGREE OF MASTER OF BUSINESS ADMINISTRATION (Finance) OF

KENYATTA UNIVERSITY

NOVEMBER, 2016
 DECLARATION

This Proposal is my original work and has not been presented for a degree in any other
University

Signed____________________________ Date______________________________

Cheruyot Bett Benard

D53/CTY/PT/28210/2014

I confirm that the work in this proposal was done by the candidate under my supervision

DR Koori.

School of Business, Department of Business Administration

Kenyatta University

Signed________________________________Date_____________________________

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 DEDICATION

This research project is dedicated to my family for their love, support both emotional and
financial, and encouragement throughout my studies as I juggled between studies, work and
family. For that I say thank you.

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 ACKNOWLEDGEMENT

All thanks goes to the Almighty God for protection, guidance, love, provision, intellect,
health and wealth. This far I have come, this would have not been possible without Gods
divine love and enablement.

Special thanks to my supervisor Dr. Koori for the continued guidance, support and direction.
Her vast knowledge highly influenced my writing. I also want to thank the Kenyatta
University Library for providing me with the research material to develop this research
project.

To my family, you are my rock and your constant encouragement has enabled me reach this
far. May God bless you.

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TABLE OF CONTENTS
DECLARATION......................................................................................................................ii
DEDICATION.........................................................................................................................iii
ACKNOWLEDGEMENT......................................................................................................iv
TABLE OF CONTENTS.........................................................................................................v
LIST OF FIGURES...............................................................................................................vii
OPERATIONAL DEFINITION OF TERMS....................................................................viii
LIST OF ABBREVIATIONS.................................................................................................ix
ABSTRACT..............................................................................................................................x
CHAPTER ONE : INTRODUCTION...................................................................................1
1.1 Background of the study....................................................................................................1
1.1.1 Concept of Leverage.......................................................................................................1
1.1.2 Firms Performance........................................................................................................2
1.1.3 Leverage and Firms Performance................................................................................3
1.1.4 Small and Medium Enterprises.....................................................................................4
1.1.5 SMEs in Kenya...............................................................................................................5
1.2 Statement of the Problem..................................................................................................5
1.3 Objectives of the Study......................................................................................................6
1.4 Hypotheses..........................................................................................................................6
1.5 Significance of the Study...................................................................................................6
1.6 Limitation of the Study......................................................................................................7
1.7 Delimitations of the Study.................................................................................................7
1.8 Assumptions of the Study..................................................................................................7
1.9 Organization of the study..................................................................................................7
CHAPTER TWO : LITERATURE REVIEW......................................................................9
2.1. Introduction.......................................................................................................................9
2.1 Theoretical Framework.....................................................................................................9
2.2 Leverage............................................................................................................................12
2.2.1 Firm Size.........................................................................................................................12
2.2.2 Growth Opportunity for Firm..........................................................................................12

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2.2.3 Firm Liquidity.................................................................................................................13
2.3 Firm Performance............................................................................................................13
2.3.1 Financial Performance Measures....................................................................................15
2.4 Empirical Review on Leverage and Firm Performance...............................................17
2.4.1 Negative effects of Leverage and Performance..............................................................17
2.4.2 Positive Effects of Leverage and Performance...............................................................19
2.5 Conceptual framework....................................................................................................20
CHAPTER THREE : RESEARCH METHODOLOGY................................................2121
3.1 Introduction......................................................................................................................21
3.2 Research design................................................................................................................21
3.3 Target population.............................................................................................................21
3.4 Sampling technique..........................................................................................................21
3.5 Sample size calculation....................................................................................................22
3.6 Data collection instruments.............................................................................................22
3.7 Reliability of Research Instrument.................................................................................23
3.8 Validity of the Research Instrument...............................................................................23
3.9 Ethical considerations......................................................................................................23
3.10 Data Analysis techniques...............................................................................................23
REFERENCES.......................................................................................................................25
LIST OF APPENDICES..........................................................................................................29

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 LIST OF FIGURES

Figure 2.1: Conceptual framework..........................................................................................20

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 OPERATIONAL DEFINITION OF TERMS

Financial Leverage Financial leverage is the degree to which a company uses

fixed-income securities such as debt and preferred equity. The
more debt financing a company uses, the higher its financial
leverage

Financial Performance a subjective measure of how well a firm can use assets from
its primary mode of business and generate revenues

Non-financial Performance Any quantitative measure of either an individual's or an

entity's performance that is not expressed in monetary units

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 LIST OF ABBREVIATIONS

CBA Cost Benefit Analysis

EVA Economic Value Added

IFC International Finance Corporation

OECD Organization for Economic CO-Operation and Development

ROA Return on Assets

ROCE Return on Capital Employed

ROI Return on Investments

SMEs Small and Medium Enterprises

SPSS Statistical Package for Social Sciences

SSC SME Solutions Center

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 ABSTRACT
In Kenya Small medium enterprises (SMEs) form a vital part of the economy. Their
economic contribution to the economy include; the generation of income, provision of new
job opportunities, introduction of new innovations, competition stimulation and an engine for
employment. The role and importance of small medium enterprises in an economy has long
attracted interest of many nations. Despite the fact that SMEs contribute a lot to the economy,
they are faced with tremendous financial challenges that threaten their will to stay alive and
remain competitive. This research study will examine the effect of Financial leverage on the
performance of small and medium enterprises in Kericho Town, Kericho county. The study
will use a descriptive research design. The study will use a sample of 384 enterprises located
within Kericho Town. Simple random sampling will be used to pick the SMEs that will
participate in the study. Primary data will be collected using questionnaires and secondary
data will be obtained from existing records. The data collected will be coded and tabulated in
a manner that is easily understood by the researcher and analyzed using Statistical Package
for Social Sciences (SPSS). Descriptive statistics will be used and information presented in
form of figures, tables, pie charts and bar charts.

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 CHAPTER ONE

INTRODUCTION

1.1 Background of the study

1.1.1 Concept of Leverage

The concept of capital structure is generally described as the proportion of long-term debt and
equity that make up the total capital of a firm. The proportion of debt and equity is a strategic
choice of corporate managers (Velnampy & Niresh, 2012). Similarly, the capital structure
decision is a significant managerial decision because it influences the shareholders return
and risk (Pandey, 2010). Consequently, the market value of a share may be affected by the
capital structure decision, and the company will have to plan its capital structure initially, at
the time of its inception. Subsequently, whenever funds have to be raised to finance
investments, a capital structure decision is involved (Pandey, 2010).

A company can finance its investments by debt and equity, and a company may also use
preference shares. The ratio of the fixed- charge sources of funds, such as debt and preference
shares to owners equity in the capital structure is described as financial leverage or gearing
(Pandey, 2010). The other alternative term trading on equity is derived from the fact that it is
the owners equity that is used as a basis to raise debt. The supplier of debt (lender) has
limited participation in the sharing of companys profits and therefore, may impose certain
restrictions (protective covenants) on the firm. Such restrictions include provision relating to
collateral, sinking funds, dividend policy and further borrowing. The issuing firm agrees to
these so-called protective covenants in order to market its bonds to investors (Bodie, Kane &
Marcus, 2004).

Financial leverage decision is a vital one since the performance of a firm is directly affected
by such decision; hence, financial managers should trade with caution when taking debt-
equity mix decision. The theory of capital structure and its relationship with firms
performance has been an issue of great concern in corporate finance and accounting literature
( Al-Taani, 2013; Mohammed, 2010; Ogebe, Ogebe & Alewi, 2013).

There are two main benefits of debt for a company. The first one is tax shield, interest
payments usually are not taxable; hence the debt can increase the value of a firm. Second
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benefit is that debt disciplines managers . Managers use free cash flows of the company to
invest in projects to pay dividends, or to hold-on cash balance. But if the firm is not
committed to some fixed payments such as interest expenses, managers could have incentives
to waste excess free cash flows. That is why in order to discipline managers, shareholders
attract debt.

It has been argued that profitable firms were less likely to depend on debt in their capital
structure than less profitable ones, and that firms with high growth rates have high debt to
equity ratios (Akintoye, 2008; ; Tian & Zeitun, 2007). Does it then mean that a firm should
go on increasing the debt proportion in its capital structure? If every increase in debt
financing were going to increase the earnings for the shareholders, then every firm would
have been 100% debt financed. However, there are certain costs associated with debt
financing. So, between the two extremes of whole equity financing and whole debt financing,
a particular debt-equity mix (financial leverage) is to be decided.

Therefore, a financial leverage decision should be designed in such a way that it maximizes
shareholders return and minimizes risk. Similarly, since the value of a firm is directly related
to its performance, financial experts study the relationship between leverage and firm
performance in order to validate Jensens (1986) theory.

1.1.2 Firms Performance

Firms performance and profitability is very important in any economy, among them are; first
the profits to the firm means income to the shareholders and hence spillover effects and
multiplier effects for individual, households and the economy in general. Secondly the
corporate taxes that the government will earn will enable the implementation of infrastructure
projects and social welfare programs. Thirdly when firms are profitable it means they can
attract more investors and hence raising large capital for bigger and high returns projects.
Finally profitable firms are able to employ more people hence creating employment which
ultimately lead poverty reduction.

Firms performance is the measurement of what has been attained by the firm, which is an
indicator of the good conditions for a period of time. The objectives of measuring
performance are to obtain very useful information about flow of funds, the uses of firm
finances, their efficiency and effectiveness. Besides, the managers are able to make best

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decisions from the information on firms performance (Almajali et al, 2012). Research has
found the following among the many factors that affect the Financial Performance of
Companies: Company Size, Leverage, Liquidity, Company Age and Management
Competence index (Almajali et al, 2012).

Profitability is very crucial for an enterprising firm. Its through profitability that investors are
willing to buy the companys shares due to enhanced reputation, and if the demand for its
shares increases the shares prices increases hence an increase in the firms value. Profitability
enables a firm to withstand negative economic shocks and enhances stability of the firm.
Profitability also maximizes the utility for shareholders through dividend and increased firm
value and stakeholders interest through corporate social responsibility (Bhutta and Hasan,
2013). Stable, established and companies that make huge profits have been seen to perform
well in good economic environment, can with stand bad economic times and recover quicker
from economic shocks than low or middle level firms.

Financial leverage has shown negative relationship to profitability in Kenya. Maina and
Kondongo (2013) using all listed firms and Mwangi et al (2014) using all non-financial listed
firms at the NSE all found negative relationship. The results are converging to a negative
relationship between leverage and profitability contrary to most theories, although they used
different data set with financial sector firms likely to affect the results of the former, while
low profitability and poor performance of some of the listed firms may affect the results of
the later.

1.1.3 Leverage and Firms Performance

Leverage is the ratio between total debt to the total assets of the firm and it indicates the
extent at which total assets are financed by debts (Mwangi et al, 2014). A higher leverage
ratio depicts the dependence of the firm on debt financing is high. There are two parties that
will be concerned about the firm performance due to leverage; one will be equity holders,
who are owners of the firm and they carry the highest risk in the business as they have a
residual claim to the assets of the firm. They are rewarded through appreciation of the value
of their share equity and through dividends. Secondly are the debt holders, they are rewarded
through interest payment and their principal will be repaid. They take assets of the firm as
collateral and have first claim on the assets of the firm in case of failure to honor the debts by
the firm

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1.1.4 Small and Medium Enterprises

Worldwide, the small and medium enterprises (SMEs) have been accepted as the engine of
economic growth and for promoting equitable development (Harash et al. 2014). Small and
medium enterprises (SMEs) are very important. The only way to reduce poverty in a
sustainable way is to promote economic growth, through wealth and employment creation in
the developing countries. Small and medium enterprises (SMEs) are the major source of
income, a breeding ground for entrepreneurs and a provider of employment in many countries
(Kraja & Osmani, 2013). Small and medium enterprises (SMEs) play a valuable role in job
creation and make signicant contributions to economic growth in developed and developing
economies alike. As a result, establishing a dynamic Small and medium enterprises (SMEs)
features prominently on the economic development agendas of practically all countries
around the world (World Bank, 2014).

In today's increasingly globalized economy, Small and medium enterprises (SMEs) are
usually feeder industries for larger industries and they are crucial for economic growth and
development (Kongolo, 2010). Small and medium enterprises (SMEs) are now considered to
be the major source of dynamism, innovation and exibility in emerging and developing
countries, as well as to the economies of most nations. They contribute substantially to
economic development and employment generation (Koh et al., 2007).

Despite their signicance, Small and medium enterprises (SMEs) are faced with the threat of
failure with past statistics indicating that three out ve fail within the rst few months. Centre
forEntrepreneurship, Small and medium enterprises (SMEs) and Local Development in
Organization for Economic CO-Operation and Development (OECD, 2009) stated that SMEs
are generally more vulnerable in times of crisis for many. The main challenges faced small
and medium enterprises (SMEs) that inhibit adequate nancing for these companies such as
poor customer knowledge, poor business enablers, lack of collateral or capital, lack of credit
data, low protability, small and medium enterprises (SMEs) skills and literacy (IFC, 2013).
Without nance, small and medium enterprises (SMEs) cannot acquire or absorb new
technologies nor can they expand to compete in global markets or even strike business
linkages with larger companies (World Bank, 2014).

The relationship between nancing and performance among the Small and medium
enterprises (SMEs) has been the subject of an important debate in the business nance

4
literature. This study investigates the effect that nancing has on performance in with specific
focus being on leverage which among the various financing sources by various SMEs.

1.1.5 SMEs in Kenya

The SME Solutions Center (SSC, 2007) defines SME as a business formally registered, with
an annual turnover of between Ksh. 8 million to Ksh. 100 million, an asset base of at least
Ksh. 4 million and 5 to 150 employees. In Kenya, SMEs play an important role in the
Economy. According to the Economic Survey (2006), the sector contributed over 50 percent
of new jobs created in the year 2005. In addition, Oketch (2000) noted that SMEs in Kenya
contribute significantly to economic development through provision of job opportunities,
reduction of poverty levels, nurturing the culture of entrepreneurship and providing a vital
link in the economy through their supply chain and intermediary role in trade.

However, despite their significance, past statistics indicate that three out of five businesses
fail within the first few months of operation (Kenya National Bureau of Statistics, 2007). Fina
Bank Report (2007) further highlighted that SMEs exhibit both high birthrates and high death
rates with 40% of the startups failing by year two and at least 60% failing by year four. Given
SMEs importance to a nation's economic growth and the critical role that they play in poverty
reduction, an understanding of the problems that negatively affect SMEs in Kenya is a
fundamental step in managing and avoiding the enormous failure of these SMEs (ILO, 2010).
Based on this background, this study is designed to establish the effect of leverage on the
financial performance of SMEs.

1.2 Statement of the Problem

In Kenya, SMEs employ 74% of the labor force and contribute over 18% of the countrys
gross domestic product. SMEs are therefore an important component of the economy,
especially with regard to absorbing a large percentage of the workforce. Good performance of
these entities is therefore critical so that they can continue with their economic contribution.
Empirical studies on the relationship between leverage and performance of SMES have
yielded conflicting results. A negative relationship between leverage and profitability was
found by Kuria (2010) and Abor (2007). Muiru and Kamau (2014) found no relationship,
while Kyule and Ngugi (2014) established a positive relationship between leverage and
profitability. The relationship between leverage and performance has not yet been

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conclusively established. Consequently, the objective of this study is therefore to determine
the effect of financial leverage on performance of SMEs in Kericho town, Kericho county.

1.3 Objectives of the Study

i. To examine the impact of financial leverage on performance of the SMEs in Kericho

town, Kericho County
ii. To draw conclusions and make relevant policy recommendations on matters
pertaining leverage for profit maximization of SMEs in Kericho Town and Kenya in
general.

1.4 Hypotheses

The study will test the following hypothesis

H0: Financial leverage has no significant effect on performance of SMEs in Kericho Town.
H1: Financial leverage has significant effect on performance of SMEs in Kericho Town.

1.5 Significance of the Study

Leverage is an influential factor on the companys returns & risk, forming a critical part of
the capital structure (combination of debt & equity). It can significantly affect the value of
the firm in a negative or positive way, as it magnifies the return & risk. Thus, concluding the
impact of financial leverage on the performance & profitability of the SMEs in Kericho town
will be beneficial for the SMES owners and managers, as it will provide an insight on the
impact of financial leverage in performance and how it may affect the financial performance.
In addition, identifying the nature of the relationship between leverage & the perfomance of
SMES will help the financial managers when making decisions that include measuring &
evaluating leverage, particularly when making capital structure decisions. Furthermore,
conducting the study and drawing a conclusion regarding the problem statement mentioned
above, will give an opportunity for future research to be conducted on the basis of the
conclusions of this study.

1.6 Limitation of the Study

Firstly, the study will be limited by finances. The researcher, being self-sponsored does not
have the financial ability to carry out a census of all the SMEs in Kericho municipality.

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Secondly, biasness is likely to affect the findings of the study. The owners of the businesses
are likely to be biased especially when giving the data pertaining to the financial performance
of the enterprises. Thirdly, some of the business are likely to be unwilling to give data. Most
of may consider data pertaining to performance as sensitive. The researcher will solve this by
providing them with an introduction letter from the university, explaining the purpose of the
activity and assuring them of the confidentiality of the data provided

1.7 Delimitations of the Study

The study will be carried out in Kericho town with focus being on SMEs. This means that the
researcher will have readily available respondents to provide information required by the
study. Large proportion of the population where the study will be carried out have the same
cultural values, thus the researcher will be able to get information from more or less
homogenous group.

1.8 Assumptions of the Study

The study will be based on the assumption that;

i. Respondents will be willing to provide the information required for the study.
ii. All SMEs within Kericho town are faced by the same challenges, opportunities and
threats.
iii. That SMEs depend on leverage in one way or another

1.9 Organization of the study

This study will be structured as follows: Chapter one will provide the research background,
statement of the problem, research objectives, research hypothesis, significance of the study,
scope, limitations and the delimitations encountered of the study. Chapter two will present the
theoretical framework of the study, literature review on the effect of financial leverage
performance, and a conceptual framework of the research. Chapter three will present the
methodology employed in the study. The study findings and their interpretation will be
presented in chapter four while chapter five will have conclusions and the recommendations
of the study.

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 CHAPTER TWO

LITERATURE REVIEW

2.1. Introduction

This study seeks to investigate the effect of financial leverage on performance of small and
medium enterprises in Kenya with emphasis on businesses in Kericho town, Kericho County.
The chapter will concentrate of literature which is a critical in-depth analysis of previous
research; it will also discuss the theoretical literature review and empirical literature review.
This study will entail review of secondary sources obtained from published work such as
journals, conference proceedings and other reports. Finally, the chapter will discuss the
conceptual framework of the study.

2.1 Theoretical Framework

Modigliani & Miller (1958) assumes that financing decisions do not matter in perfect capital
markets. The level of debt in the firm's capital structure would have no impact on the firm's
value, performance and shareholders' value. Modigliani and Miller first preposition was that
the market value of any firm is independent of its capital structure and is given by
capitalizing its expected return at the rate appropriate to its class. Modigliani and Miller
second preposition was that the expected yield of a share of stock is equal to the appropriate
capitalization rate for an equity stream in the same risk class, plus a premium related to
financial risk equal to the debt-equity ratio times the spread between the capitalization rate
and the cost of debt.

The preposition indicated that as debt-equity ratio increases, the expected return on equity
will also increase as long as the debt was risk-free. However as leverage increases the risk of
debt, the debt holders also require more return on their debt and this causes the increase in the
return on equity to slow down. Modigliani and Miller (1963) expanded their work and
incorporated corporate taxes to the model of corporate valuation by assuming that the value
of a levered firm equals the value of an un-levered firm plus a premium derived by
discounting to perpetuity the stream of tax savings which is applicable so long as the firm has
sufficient taxable capacity. Because interest expenses are tax-deductible but dividends are

8
not, this encourages firms to use more debt, and the value of the levered firm will equal that
of an un-levered firm plus the present value of tax shield provided by debt.

Miller (1977) modified the theory by introducing both corporate and personal taxes. He states
that the firm has an incentive to use debt, and will continue to do that until its additional
supply of debt drives up interest rates to the point where the tax advantages of interest
deduction are completely offset by higher rates. This will be the point at which the marginal
investors personal tax equals the corporate tax rate. Additionally, the advantage from using
debt is zero if the income tax rates for stocks and bonds are equal, and the firm's performance
and value is independent of the method of financing. According to Kraus & Litzenberger
(1973) static tradeoff theory affirms that firms have optimal capital structures which they
determine by trading off the costs against the benefits of the use of debt and equity.

The theory suggests that debt has a central role in firm financing. The firm substitutes debt
for equity or equity for debt until the value of the firm is maximized. Static trade-off theory
predicts a negative relation between a firms growth opportunity and financial leverage ratio;
because growth firms can incur much higher financial distress costs and lower agency costs
of free cash flow. Among the benefits of the use of debt is the advantage of a debt tax shield.
One of the disadvantages of debt is the cost of potential financial distress, especially when the
firm relies on too much debt. This leads to a trade-off between the tax benefit and the
disadvantage of higher risk of financial distress. But there are more cost and benefits
involved with the use of debt and equity.

One other major cost factor consists of agency costs. Jensen (1986) argues that debt is an
efficient means by which to reduce the agency costs associated with equity. Agency costs
stem from conflicts of interest between the different stakeholders of the firm and because of
ex post asymmetric information Jensen and Meckling (1976).Hence, incorporating agency
costs into the static trade-off theory means that a firm determines its capital structure by
trading off the tax advantage of debt against the costs of financial distress of too much debt
and the agency costs of debt against the agency cost of equity.

Therefore, the prediction of the static trade-off theory is that firms target their capital
structures. Myers (1984) indicated that a firm shows a distinct preference for using internal
finance (as retained earnings or excess liquid assets) over external finance and debt to equity
if the firm issues securities. If internal funds are not enough to finance investment

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opportunities, firms may or may not acquire external financing, and if they do, they will
choose among the different external finance sources in such a way as to minimise additional
costs of asymmetric information. The pecking order was traditionally explained by
transaction and issuing costs.

Retained earnings involve few transaction costs and issuing debt incurs lower transaction
costs than equity issues. Debt financing also involves a tax reduction if the firm has a taxable
profit. Myers and Majluf (1984) invoked asymmetric information to give a theoretical
explanation for the pecking order phenomena. The signalling model showed that only low
profit type firms would issue equity in a separating equilibrium. To avoid this discount,
managers avoid equity whenever possible. The agency theory for free cash flows by Jensen
(1986) suggests that the use of debt can reduce the free cash flow available to managers and
constrain or encourage them to act more in the interests of shareholders. Debt is used to
control the managers' opportunistic behaviour by reducing the free cash flows in their hands.
This will prevent the investment in negative projects by committing the management to pay
fixed interest payments.

The agency cost theory is premised on its preference for higher debt in financing when
agency problem becomes pronounced. The market timing theory of capital structure argues
that managers look at current conditions in both debt and equity markets. If they need
financing, they use whichever market currently looks more favourable (Boudry, Kallberg &
Liu, 2010).If neither market looks favourable, they may defer issuances. Alternatively, if
current conditions look unusually favourable, funds may be raised even if the firm has no
need for funds currently. Firms time their equity issues in the sense that they issue new stock
when the stock price is perceived to be overvalued, and buy back own shares when there is
undervaluation. Consequently, fluctuations in stock prices affect firm capital structure.

Companies are assumed to issue equity directly after a positive information release which
reduces the asymmetry problem between the firms Management and stockholders. The
decrease in information asymmetry coincides with an increase in the stock price. In response,
firms create their own timing opportunities. In a study by Graham and Harvey (2001)
managers admitted trying to time the equity market, and most of those that have considered
issuing common stock report that the amount by which our stock is undervalued or over-
valued was an important consideration. Baker and Wurgler (2002) provide evidence that
equity market timing has a persistent effect on the capital structure of the firm. They find that
10
leverage changes are strongly and positively related to their market timing measure, so they
conclude that the capital structure of a firm is the cumulative outcome of past attempts to
time the equity market.

2.2 Leverage

Capital structure is the mix of debt (leverage) and equity capital used to finance a firms
operations (Ebaid, 2009).Leverage involves the use of fixed costs to magnify a firms return
(Pandey, 2005).Debt can be classified either as short term debts, long term debt or total debt.
Generally increases in leverage results in increased return and risk, whereas decreases in
leverage result in decreased return and risk (Imad, 2013). The debt level of different firms
may be explained by the following factors.

2.2.1 Firm Size

Firm size can either be measured by level of assets or magnitude of sales. Firm size was
measured by natural logarithm of total assets as used by (Onaolapo and Kajola, 2010).The
trade-off theory suggest that larger firms should operate at high debt levels due to their ability
to diversify the risk and to take the benefit of tax shields on interest payments. Large firms
usually are more diversified and have lower variance in earnings and hence can accommodate
high debt ratios. Smaller firms on the other hand may find it relatively more costly to
incorporate debt in their operation. Thus larger firms will have higher debt levels than smaller
firms. Empirical evidence on the relationship between size and capital structure supports a
positive relationship. Al-Sakran (2001) suggested that smaller firms are likely to use equity
finance while larger firms are likely to use debt.

2.2.2 Growth Opportunity for Firm

Growth opportunity for firm is an important determinant of firm capital structure. A good
indicator for growth is related to the change in total sales or the total assets (Onaolapo and
Kajola, 2010). Static trade-off theory predicts a negative relation between a firms growth
opportunity and financial leverage ratio; because growth firms can incur much higher
financial distress costs and lower agency costs of free cash flow. Therefore they tend to
reduce their financial leverage. On the contrary, pecking order theory implies that firms with
higher growth opportunities make more investments. To finance these investment projects,

11
firms have to issue more debt. Thus the relation between a firms growth opportunity and
financial leverage ratio is positive. Firms with high growth opportunity tend to use equity
financing rather than debt financing, since they do not want to pass up future profitable
investment opportunities.

2.2.3 Firm Liquidity

A Firms liquidity is the ability of the firm to meet its short-term obligations; it is defined as
the ratio of current assets to current liability (Pandey, 2005). According to the free cash free
theory, Firms with high liquidity may have high debt because of their ability to meet short-
term liabilities which means a positive relationship between liquidity and debt level. Jensen
and Meckling (1976) argued that managerial incentives to allocate the firms resources to
their private benefit are larger when the firm is mainly equity financed. Debt creation enables
managers to effectively bond their promise to pay out future cash flows. According to the
pecking-order theory, high liquidity firms have the choice to use their assets as an internal
financing source instead of issuing debt to finance their projects. This indicates a negative
relationship with debt (Khan, 2012). Firms with high liquidity may have high debt because of
their ability to meet short-term liabilities.

2.3 Firm Performance

Performance is the fundamental goal of every business and every organization. Firm
performance comprises of the actual output or results of the organization as measured against
its intended outputs (or goals and objectives). The concept of business performance is
founded upon the idea that a business is the intended relationship of productive assets,
including human, physical, and capital resources, with an aim of attaining a shared purpose
(Barney, 2001). Those availing the assets will only commit them to the business provided that
they are contented with the value they get in return, relative to alternative uses of the assets.
As a result, the purpose of performance is value creation. As long as the value created by the
use of the contributed assets is equivalent to or greater than the value expected by those
contributing the assets, the assets will continue to be availed to the business and the business
will continue to exist. Thus, value creation, as defined by the resource provider, is significant
as the overall performance criteria for any business.

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Performance can either be financial or non-financial. Financial performance is a measure of
the change of an enterprises financial status or the financial outcomes that occur as a result
from management decisions and the execution of those decisions by the stakeholders in the
business. Since the perception of these outcomes is contextual, the measures used to represent
performance are selected based upon the circumstances of the business being observed. The
measures chosen represent the results attained, either good or bad. Most management
research studies focuses on the determinants of performance. Performance as a concept
involves measurement of the effects of organizational actions.

Performance can also be non-financial. Oslon, Slater and Hult, (2005) denote that non
financial performance is presented in terms of growth in market share, growth in number of
employees among others. Growth in number of employees is the most common measure used
to measure the success of small firms (Bigsten and Gebreeyesus, 2007). Growth in the
number of employees is however used as a measure of performance in cases where there is no
financial data in existent. The implicit assumption is that growth in employment size is
associated with higher profits. The main justification for relying on employment growth as an
indicator of success is that use of other dimensions of success indicators will become more
complicated when, for example, firms do not keep complete books of records. Employment
growth can also be justified as a conservative measure of firm success because a firm usually
employs more labour long after it has realized profit. Garoma (2012) argues that owing to its
objectivity and ease of obtaining data, many researchers study success using employment
growth.

Performance can also be measured non-financially using own perception. According to

Garoma (2012), success is a subjective concept and can better be explained by respondents.
World Bank (2007) advocated that understanding how people perceive their jobs is an equally
key indicator of performance as objective measures. Employees and clients perceptions in
this case can be used to measure the performance of organization. In this case, lower
satisfaction measures indicate poor performance while high satisfaction levels indicate good
performance.

Other non-financial measures of performance are; time delivery, brand recognition, position
in favourable markets, product quality, level of innovation, manufacturing productivity, yield
and resource conservation. Concerning delivery, on time deliveries signifies good
performance while delayed deliveries indicates poor performance (Ittner and Larcker 2001).
13
On brand recognition, highly recognized brands indicate that the company owning the brand
is performing well while those with poorly recognized brands are regarded as poor
performers. Regarding positioning in the markets, firms that suitably positioned in a
competitive market signifies that the firm is performing well while those poorly positioned in
the competitive markets are regarded as poorly performing. Firms with high manufacturing
productivity, low or lack of innovative strategies, poor yields, high wastage of resources,
management and employees incompetence, low working morale, and poor levels of
education and training are regarded as poor performers and the reverse is true for good
performing firms.

2.3.1 Financial Performance Measures

Measures of corporate performance are numerous. Traditional common measures include;

Return on Investments (ROI), Return on Assets (ROA), Return on Capital Employed
(ROCE), Cost Benefit Analysis (CBA) and Economic Value Added (EVA).

Return on Investments (ROI) is a performance measure used to evaluate the efficiency of an

investment or to compare the efficiency of different investments. To calculate ROI, the
benefit (return) of an investment is divided by the cost of the investment; the result is
expressed as a percentage or a ratio.

ROI = Gain from investment Cost of investment Cost of investment

In the formula above, gains from investment refers to the proceeds obtained from selling the
investment or interest. Return on investment is a very popular measure because of its
versatility and simplicity. If an investment does not have a positive ROI, or if there are other
opportunities with a higher ROI, then the investment should not be undertaken.

Return on Assets (ROA) is an indicator of how profitable a company is relative to its total
assets. ROA gives an idea as to how efficient management is at using its assets to generate
earnings. It is calculated by dividing a companys annual earnings by its total assets. It is
computed as follows:

ROA = Net income / Total assets (expressed as a percentage)

14
ROA tells us what earnings were generated from invested capital (assets). ROA for public
companies can vary substantially and will be highly dependent on the industry.

Return on Capital Employed (ROCE) is an indicator of the efficiency and profitability of a

companys capital investment. It is one of the most important operating ratios that can be
used to assess corporate profitability. It is expressed as a percentage and can be very
revealing about the industry in which a company operates in, the skills of management and
occasionally the general business climate. As a general rule, a firm with a high return on
capital employed will probably be a very profitable business. ROCE is calculated as follows:

ROCE = Net Income/ Capital Employed

Where Capital Employed = Total Assets Current Liabilities = Equity + Non-Current

Liabilities

Cost Benefit Analysis (CBA) is an economic decision-making approach used particularly in

government and business organizations. It is used in the assessment of whether a proposed
project, programme or policy is worth doing or to choose between several alternative ones. It
involves comparing the total expected costs of each option against the total expected benefits
to see whether the benefits outweigh the costs and by how much. In CBA, benefits and costs
are expressed in money terms and are adjusted for the time value of money so that all flows
of benefits and flows of project costs over time (which tend to occur at different points in
time) are expressed on a common basis in terms of their present value.

Economic Value Added is a registered trademark of Stern Stewart & Company and is an
estimate of a firms economic profit being the value created in excess of the required return of
the companys investors (i.e. shareholders and debt holders). EVA is the profit earned by the
firm less the cost of financing the firms capital. The idea is that value is created when the
return on the firms economic capital employed is greater than the cost of that capital. Just
earning profit is not enough, a business should earn sufficient profit to cover its cost of
capital and create surplus to grow. Stated simply, any profit earned over and above the cost of
capital is Economic Value Added (Malik and Rakshit, 2005). EVA is a measure of corporate
surplus that should be shared by the employees, management and shareholders. It focuses on
clear surplus in contradiction to the traditionally used profit available to the shareholders.
EVA is used by companies as a performance indicator and also as a basis for executive

15
compensation. Surplus should be derived by deducting cost of capital from before interest but
after tax.

EVA = NOPAT (WACC X Capital Employed)

Where NOPAT refers to Net Operating Profit before Interest and After Tax while WACC
represents Weighted Average Cost of Capital. For the purpose of this study, ROA will be
used.

2.4 Empirical Review on Leverage and Firm Performance

Many researchers have investigated the relationship between leverage and firms performance
for various industry sectors. The various researchers concluded both positive and negative
association between the debt level and firms performance.

2.4.1 Negative effects of Leverage and Performance

Studies that have established a negative association between financial leverage and return on
equity are presented as follows: Mwangi et al (2014) studied the relationship between capital
structure and performance of non-financial companies listed in the Nairobi Securities
Exchange in Kenya and concluded that increased financial leverage has a negative effect on
performance. Imad Z. R. (2013) investigated the debt-performance relation for 77 Jordanian
industrial companies over the period between 2000 and 2011.The results of analysis showed
that debt structure expressed as: long-term debt, short-term debt, and total debt have a
significantly negative relationship with Return on Assets.

Abbasali and Esfandiar (2012) investigated the impact of capital structure on the financial
performance of companies listed in the Tehran Stock Exchange and tested a sample of 400
firm. They concluded that there was a significant negative relationship between debt ratio and
financial performance of companies, and a significant positive relationship between asset
turnover, firm size, asset tangibility ratio, and growth opportunities with financial
performance measures. Nima et al (2012) investigated the possible relationship between
current debt, non-current debt, and total debt as proxies for capital structure, and the
performance of Iranian companies listed at Tehran Stock Exchange. The study concluded that
the proxies of the capital structure of the Iranian firms have a negative effect on the Iranians
firms performance.

16
Khan (2012) tested the impact of the debt structure on the firms performance for the
Pakistanian companies. The study concluded that the short term debt and total debt as proxies
of debt structure have a significantly negative effect on the firms return on assets, a proxy of
the firms performance. Saeedi and Mahmoodi (2011) evaluated the association between
capital structure and firms profitability. Their result shows that firms profitability measured
by earnings per share and Tobins Q, are positively affected by capital structure, whereas the
Returns on Assets associated negatively with the capital structure, and no significant
association between Returns on Equity and capital structure.

Onaolapo and Kajola (2010) investigated the effect of capital structure on financial
performance of companies listed on Nigeria Stock Exchange. This study was performed on
30 nonfinancial companies in 15 industry sectors in a 7-year period from 2001 to 2007. The
results showed that the capital structure (debt ratio) has a significant negative effect on
measures of financial performance of these companies. Ebaid (2009) established a very weak
relationship between the debt structure and the firms performance for the Egyptian firms.
The study concluded that the relation between the proxies of the debt structure and the ROE
is insignificant. While the short term debt and total debt to total assets has a negative and
statistically significant effect on the firms ROA.

Zeitun and Tian (2007) surveyed the impact of capital structure on the firm performance for
167 Jordanian companies during 1989 to 2003. The results suggested that capital structure
has significantly negative impact on accounting measures of firm performance evaluation.
Also they indicated that short-term debt to total assets ratio has significantly negative impact
on market measure of Jordanian companies performance evaluation. Abor (2005) examined
the relationship between capital structure and profitability of listed firms on the Ghana Stock
Exchange for a five-year period. A negative relationship between the ratio of long-term debt
to total assets and return on equity was found.

Sogorb (2005) surveyed the impact of small and medium companys features on their capital
structure in Spain during 1994 to 1998 and used data of 6,482 nonfinancial companies in 8
industries. Results showed that tax reserves and profitability of these companies have
negative relationship with capital structure while size, growth opportunities and assets
structure in these companies have positive relationship with capital structure. Majumdar and
Chhibber, (1999) examined the relationship between the levels of debt in the capital structure
and performance for a sample of Indian firms. The conclusion from the analysis of the data
17
indicated a significantly negative relationship between the levels of debt in the capital
structure and performance for the Indian firm investigated.

Rajan and Zingales (1995) studied the determinant factors of capital structure of common
company corporations in seven large countries around the world (America, Japan, Germany,
France, Italy, Britain and Canada) during 1987 to 1991. In this study, they chose 4557
companies as samples of these seven countries. The findings indicated that financial leverage
has negative relationship with profitability.

2.4.2 Positive Effects of Leverage and Performance

Studies that establish a positive association between financial leverage and return on equity
are presented as follows: Zuraidah et al. (2012) explored the effect of the capital structure on
firms profitability by using ROA and ROE as proxies for the performance, and short-term
debt, long-term debt and total debt as proxies for the capital structure. The study concluded
that short-term debt and total debt have a significant association with ROA. Aburub (2012)
investigated the impact of capital structure on the firm performance of companies listed in
Palestine Stock Exchange during 2006 to 2010 in which 28 companies were selected in the
sample. In this study, five measures of Return On Equity, return on assets, earnings per share,
market value to book value of equity ratio and Tobin Q ratio as the measures of accounting
and market of firm performance evaluation and also as dependent variables and four
measures of short-term debt to total assets ratio, long-term debt to total assets ratio, total debt
to total assets ratio and total debt to total equity ratio as the measures of capital structure and
also as the independent variables were selected. Results indicated that the capital structure
has a positive effect on firm performance evaluation measures.

18
2.5 Conceptual framework

Conceptual frameworks presents the pictorial representation of the study variables. In this
study, leverage (debt to equity ratio) forms the independent variable while performance (
Financial and Non-Financial) forms the dependent variable. The intervening variable is
the government through policies.

Independent variable
variables Dependent
Leverage
variable variables
Debt to equity ratio Financial performance
ROA
Non-Financial
Performance
Number of
employees
Number of branches

Intervening variable

Government variables
intervention

Figure 2.1: Conceptual framework

19
 CHAPTER THREE

RESEARCH METHODOLOGY

3.1 Introduction

This chapter presents a systematic discussion on research strategy to be adopted in

establishing the effect of leverage on performance of SMEs. The chapter presents the
research methodology under the following subsections; the research design, target population,
sampling procedure and sample size, research instruments, validity and reliability, data
analysis procedures and ethical considerations.

3.2 Research design

The study will use a descriptive design to examine the effect of microfinance institutions on
growth and development of SMEs in Kericho town. A descriptive design will be suitable in
the study owing to the fact that several SMEs will be sampled. A descriptive design describes
people responses to questions about a phenomenon or situation with aim of understanding
respondents perceptions from which truism is constructed (KIM, 2009). This is based on the
constructivist epistemology which holds that reality is what respondents generally perceive to
be. A descriptive design is particularly useful as the study seeks to establish the perception of
respondents in reference to effect of leverage on performance of SMEs.

3.3 Target population

The target population for the study will be the SMEs operating in Kericho Town. The
respondents of interest in this study will be the SMEs owners/ Managers.

3.4 Sampling technique

Sampling is defined by Chandran (2004), as a method used in drawing samples from a

population usually in such a manner that the sample facilitated determination of some
hypothesis concerning the population. This study will sample one categories of population

20
required to provide information for the study. This is small and medium enterprises within
Kericho town. The sampling frame for SMEs will be drawn from the list of SME in Kericho
Municipal Council (2016). Simple random sampling will be used to select SMEs to
participate in the study.

3.5 Sample size calculation

n= z2 p (1-p)
ME2
Where n=Sample size

Z is the Z-score= 1.96 for a 95% confidence interval

P=0.5

ME= the desired margin of error

Therefore

n=1.962 0.5(0.5)

0.052

n=1.962 0.25

0.0025

n=3.84 (100)

n= 384 SMEs

3.6 Data collection instruments

The researcher will use both secondary and primary data to accomplish the research
objectives. Primary data will be collected through questionnaires administered to managers of
the SMEs. According to Chandran (2004), questionnaires provide a high degree of data
standardization and adoption of generalized information amongst any population. They are

21
useful in a descriptive study where there is need to quickly and easily get information from
people in a non-threatening way. They provide flexibility at the creation phase in deciding
how questions were administered. Secondary data will be gathered

3.7 Reliability of Research Instrument

Reliability was undertaken through a pilot test. According to (Polit, 2001), pilot studies are
small scale version[s], or trial run[s], done in preparation for the major study. He further adds
that it can be used for pre- testing of a research instrument. Baker (1994) indicates that one
advantage of conducting a pilot study is that it might give advance warning about where the
main research project could fail, where research protocols may not be followed, or whether
proposed methods or instruments are inappropriate or too complicated. The researchers will
issue questionnaires to selected respondents in the SMEs. The results of the pilot test and
issues emanating from the questionnaire will then be used to correct the main questionnaire
before actual data collection is undertaken.

3.8 Validity of the Research Instrument

Content validity will be used to examine whether the questionnaire will test what it intends to
test. Validity of the instrument will be obtained through the opinion research panel experts
and supervisors. The opinions of the experts will be incorporated in the final questionnaire to
be used to collect data in the field.

3.9 Ethical considerations

The researcher will seek consent to carry out the study from municipal council of Kericho.
Other ethical considerations that the researcher will take include ensuring anonymity for the
respondents and organizations participating in the study as well as the respondents. All
sources of information that does not belong to the researcher will be acknowledged through
citations.

3.10 Data Analysis techniques

Quantitative and qualitative techniques will be used to undertake data analysis. Qualitative
data analysis will involve explanation of information obtained from the empirical literature
open ended questions from the questionnaire. Quantitative analysis will involve use of

22
numeric measures in establishing the scores of responses provided. This will entail generation
of descriptive statistics after data collection, estimation of population parameters from the
statistics, and making of inferences based on the statistical findings, with help of Statistical
Package for Social Sciences (SPSS) version 22. A simple linear regression will be used to
establish the relationship between leverage and performance of SMEs within Kericho town.
This linear regression model is as shown below.

Y= 0+1(Leverage)+

Where Y=Dependent variable (Perfomance of SMEs)

0 = the constant of the model,

1= the coefficient of leverage

=the error

Strength of the relationship will be determined by the value of R .The value of R ranges from
0 to 1.Values of 0 show no relationship, while 0.5 show moderate relationship and values
above 0.7 show strong relationship. The statistical test of significance will be performed at
the 95% confidence level. The results of the analysis will then be interpreted based on the
research objectives and thereafter conclusions and recommendations will be made.

23
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27
LIST OF APPENDICES

APPENDIX I: INTRODUCTORY LETTER

Dear Respondent

RE: RESEARCH PROJECT

This questionnaire is designed to gather information on the effects of financial leverage on

performance of small and medium enterprises in Kericho town, Kericho county. The study is
purely for academic purpose and is a requirement in partial fulfillment of the award of the
Degree of Master of science in finance of Kenyatta University. Your response will be treated
with utmost confidentiality and under no circumstance will your identity be revealed. Your
co-operation will be highly appreciated.

Yours faithfully

Benard

Researcher

28
APPENDIX II: RESEARCH QUESTIONNAIRE

This questionnaire is intended to gather data to be used in assessing the effects of financial
leverage on performance of small and medium enterprises in Kericho town, Kericho county.
The information given in this questionnaire will be treated as private and confidential and
will only be used by the researcher for academic purposes.

SECTION A: GENERAL INFORMATION

1. Gender

Male ( )

Female ( )

2. Age

Under 30years

Between 30-39 years

Between 40-49 years

Above 50 years

3. Level of education attained

Primary

Secondary

College

4. Position in the business

Director

Employee

29
5. Nature of business:

(Please indicate what the business deals with)

Communication ( )

Agricultural produces ( )

Health services ( )

Manufacturing ( )

Restaurant and Entertainment ( )

Repair contractors ( )

ICT service providers ( )

Filling stations ( )

Others (Specify) __________

6. How long has the business been in existence?

1-5 years

6-10 years

Above 10 years

7. How can you rate your performance?

Very good Good Average below Average

9. Has your business grown in the past three years?

Yes

No

30
SECTION B: FINANCIAL LEVERAGE AND PERFORMANCE

8. This section seeks to collect data pertaining to leverage, financial and non-financial
indicators of performance. Note that this data is only meant for academic purpose and high
confidentiality is guaranteed

Non-Financial Indicators

2013 2014 2015 2016

Number of employees
Number of branches
Financial Indicators

2013 2014 2015 2016

Total Liabilities (Debts)
Total Equity
Annual net Income
Average Total Assets

SECTION C: EFFECT OF GOVERNMENT POLICIES ON PERFORMANCE OF

SMES

9. What is your opinion on the way the government is treating small business owners?
___________________________________________________________________________
___________________________________________________________________________
_

10. Do you think that the government has in some ways contributed to the failure or success
of small businesses in Kenya?

___________________________________________________________________________
____

31
24. In your opinion, what do you think the government should do to enhance performance of
SMEs?
_____________________________________________________________________

THANK YOU FOR YOUR COOPERATION

32
APPENDIX III: BUDGET

ACTIVITY COST (IN KSHS.)

Photocopying and Printing 20,000
Typing and printing 10,000
Binding 4,000
Transport 10,000
Communication 5,000
Data collection 20,000
Miscellaneous 5,000
Total 74,000

33