Effect of Capital Structure on Financial Performance of Commercial Banks in Kenya

Abstract

The impact of capital structure on the value of the firm has been a puzzling issue in corporate finance since the capital structure “irrelevance” proposition introduced in 1958 by Modigliani and Miller. To date, determining the mix in the firm’s capital that will improve a firm’s value is a contentious topic in financial literature. This study evaluated the effect of capital structure on financial performance of commercial banks in Kenya by determining the effect of short term debt asset ratio, long term debt asset ratio, interbank borrowings and equity on financial performance. In evaluating the relationship between the variables, a descriptive research design was applied. The target population was all the 43 commercial banks in Kenya. A panel data model was used to analyze all data from 34 commercial banks that had been in operation over a study period of 10 years (2005 – 2014). The study period was appropriate as it covered various cycles in the Kenyan banking sector. The results of the study will be useful to all those interested in bank policy making. The study established that interbank borrowing and equity have significant positive effect on profitability. However short-term debt and long-term debt asset ratio do not have a significant effect on profitability. The following recommendations are made. First, since long term or short-term debt to asset ratios do not significantly affect profitability of commercial banks, the study recommends to bank managers to focus on finding a satisfactory debt level that satisfies regulations and focus on other variables that, may be critical in influencing profitability. Secondly, the study recommends bank managers to focus on improving the capital strengths of their banks by either rights issue, bonus issue of shares or through high retention of profits. Lastly, Bank managers should devise effective relationships with other banks so as to be able to access lending from them when needs arise.