The Impact of Financial Leverage on the Performance of Commercial Banks: Evidence from Selected Commercial Banks in Ethiopia

Desta Zelalem

doi:10.11648/j.ijafrm.20200501.16

Abstract

The financing decision function of corporate finance deals with determining the best financing mix or capital structure of the firm in order to maximize the value of firm or wealth of owners. In Ethiopia, Commercial Banks use a combination of debt and equity source of finance in their capital structure. Each source of finance has its own cost of capital in the capital structure and hence effect on value of corporation. The ratio used to measure the proportion of debt to equity is considered as Financial Leverage. The main objective of this study is to investigate the effect of financial leverage on the financial performance of Ethiopian Commercial Banks for the period of 10 years (2008-2017) for the 5 selected commercial banks. As a measure of financial leverage for the independent variables three variables such as Debt ratio (DR), Debt Equity ratio (DER) and Interest coverage ratio (ICR) (times interest earned ratio) were used. As a measure of financial performance, the dependent variable two ratios such as return on asset (ROA) and return on equity (ROE) were used. The ex-post facto and longitudinal research design were used. The secondary data were collected from the audited financial reports (profit and loss statement and statement of financial position) of selected commercial banks operated in Ethiopian financial system. Descriptive statistics and Fixed Effect model were used. The result of the study showed that, Debt Ratio (DR) has a negative insignificant effect on Banks’ performance measured by Return on Assets (ROA) and Return on Equity (ROE) while Debt Equity Ratio (DER) And Interest Coverage Ratio (ICR) have significant positive Effect on Banks’ performance measured by Return on Assets (ROA) and Return on Equity (ROE).

Highlights

The sources of long-term funding for a business are divided into two main categories, owners’ funding and borrowed funding
This study focuses on how financial leverage affects the financial performance of selected Commercial Banks in Ethiopia measured by Return on Assets (ROA) and Return on Equity (ROE)
Sd 0.0111 0.167 1.998 5.252 1.417 1.333. As it is presented in the above table 1; the descriptive statistics shows that over the period under study, the financial leverage measured by Debt Ratio (DR), Debt Equity Ratio (DER), Interest Coverage Ratio and Cash Coverage Ratio (CCR) have positive mean value which ranges from 1.380 for Debt Ratio (DR) to 8.977 for Debt Equity Ratio (DER)

Summary

Introduction

The sources of long-term funding for a business are divided into two main categories, owners’ funding (equity) and borrowed funding (debt). [2] In her study on “Impact of leverage on Profitability of Pantaloon Retail India Ltd” had stated that finance decision was concerned with selection of correct mix of debt and equity in its capital structure. The results of the study explain that increase in the leverage may reduce the agency cost In this study they stated that if the leverage is increased from the optimal level those results in the opposite put effect on the agency cost of free cash flow. They discussed that sometimes increase in the debt causes bankruptcy cost. They said that the increase in the debt level reduces the agency cost but increases the bankruptcy cost

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Results

Discussion

Conclusion