Finance, Markets and Valuation Vol. 8, Num. 2 (July-December 2022), 37–57
How to cite: Mugisha, H; Omagwa, J.; Kilika, J. (2022) Capital Structure, Financial Capacity and Financial Performance
of Small and Medium Enterprises in the Buganda Region, Uganda. Finance, Markets and Valuation, 8(2), 37–57. DOI:
https://doi.org/10.46503/GTOS1775
37
Capital Structure, Financial Capacity and Financial
Performance of Small and Medium Enterprises in the
Buganda Region, Uganda
Estructura de capital, capacidad financiera y rendimiento
financiero de pequeñas y medianas empresas en la region de
Buganda, Uganda
Henry Mugisha1, Job Omagwa2, James Kilika3
1Department of Accounting and Finance, Uganda Christian University, Kampala, Uganda:
email:hmugisha2@gmail.com. https://orcid.org/0000-0001-8957-8658
2Department of Accounting and Finance, Kenyatta University, Nairobi, Kenya.
email: jobomagwa@hotmail.com. https://orcid.org/0000-002-6852-2863
3Department of Business Administration, Kenyatta University Nairobi, Kenya.
email: jmkilika@gmail.com. https://orcid.org/0000-0001-5857-7628
JEL: Classification: G02; G11; G32
_____________________________________________________________________
Abstract
Small and medium scale enterprises (SMEs) are drivers of economic growth in developed and
emerging economies like Uganda. Although they constitute a large proportion of businesses,
the SMEs’ financial performance has been unstable over the years, and in extant literature this
issue has been attributed to capital structure and other financing decisions. Empirical evidence
indicates that more than 50% of SMEs in Uganda cease their operations within the first three
years of operation, citing financial capacity issues such as inadequate liquidity. Hence, the aim
of this work was to determine the mediating effect of financial capacity in the relationship
between SME capital structure and financial performance. The study design was anchored in
the agency, free cash flow, and stakeholder theories and the relevant data were gathered via a
cross-sectional survey. A stratified sampling method was used to identify SMEs operating in the
target area, and one respondent was purposively selected from every chosen SME. Although
questionnaires were sent to 453 SMEs, only 423 valid questionnaires were obtained and were
subjected to further analyses. Data were analyzed using descriptive statistics and multivariate
analysis. The mediation test results indicate a partial but statistically significant mediation
effect of financial capacity in the capital structure−financial performance relationship. We thus
conclude that high levels of financial capacity strengthen the effect of capital structure on the
financial performance of SMEs. Consequently, we recommend that SMEs maintain optimal
levels of liquidity as well as financial solvency to optimize financial performance.
Keywords: Capital structure; Financial capacity; Financial performance
_____________________________________________________________________
DOI: 10.46503/GTOS1775
Corresponding author
Henry Mugisha
Received: 05 SEP 2022
Revised: 13 SEP 2022
Accepted: 03 NOV 2022
Finance, Markets and Valuation
ISSN 2530-3163.
Finance, Markets and Valuation
Finance, Markets and Valuation Vol. 8, Num. 2 (July-December 2022), 37–57
_____________________________________________________________________
Henry Mugisha, Job Omagwa, James Kilika 38
Abstract
Las pequeñas y medianas empresas (PYMES) son el motor del crecimiento económico en las
economías desarrolladas y emergentes como Uganda. Aunque constituyen una gran
proporción de empresas, los resultados financieros de las PYME han sido inestables a lo largo
de los años, y en la literatura existente este problema se ha atribuido a la estructura de capital
y a otras decisiones de financiación. Los datos empíricos indican que más del 50% de las PYME
de Uganda cesan sus operaciones en los tres primeros años de funcionamiento, alegando
problemas de capacidad financiera como la falta de liquidez. Por lo tanto, el objetivo de este
trabajo era determinar el efecto mediador de la capacidad financiera en la relación entre la
estructura de capital de las PYME y los resultados financieros. El diseño del estudio se basó en
las teorías de la agencia, el flujo de caja libre y las partes interesadas, y los datos pertinentes se
recogieron mediante una encuesta transversal. Se utilizó un método de muestreo estratificado
para identificar a las PYME que operan en la zona objetivo, y se seleccionó intencionadamente
un encuestado de cada PYME elegida. Aunque se enviaron cuestionarios a 453 PYMES, sólo se
obtuvieron 423 cuestionarios válidos que se sometieron a análisis posteriores. Los datos se
analizaron mediante estadísticas descriptivas y análisis multivariantes. Los resultados de la
prueba de mediación indican un efecto de mediación parcial pero estadísticamente significativo
de la capacidad financiera en la relación estructura de capital-rendimiento financiero. Por
tanto, concluimos que unos niveles elevados de capacidad financiera refuerzan el efecto de la
estructura de capital sobre los resultados financieros de las PYME. En consecuencia,
recomendamos que las PYME mantengan niveles óptimos de liquidez, así como de solvencia
financiera, para optimizar el rendimiento financiero.
Keywords: Estructura de capital, Capacidad financiera; Rendimiento financiero
_____________________________________________________________________
1. Introduction)
According to the Organisation for Economic Cooperation and Development
(2017), small and medium-scale enterprises (SMEs) are credited for stimulating inclusive
economic development, creation of employment, and promotion of reduction in income
disparities among world communities. The same report maintains that SMEs make up
the largest proportion of business establishments globally. Despite their dominance in
the business industry, SMEs continue to face financial performance challenges in
emerging and developed economies alike (Nikolić et al., 2019). This has weakened their
implied mandate of job creation and mobilization of government revenue. Extant
research further indicates that majority of small and medium firms stagnate and
eventually cease operations, citing financial capacity issues such as inadequate liquidity
(Matar & Eneizan, 2018; Reeg, 2013).
The documented financial performance failure of SMEs continues to dominate
the capital structure decisions debate among the various industry stakeholders (Nikolić
et al., 2019). In most cases, the SMEs’ financial performance failure is attributed to the
growth constraints, including insufficient liquidity conditioned by lack of access to credit,
as well as inadequate proprietary equity capital. For instance, extant literature indicates
that SMEs lack the requisite collateralizable assets to enable them to obtain credit from
formal financiers (Nikolić et al., 2015). As a result, the financial capacity of firms to offset
their obligations is constrained in both short and long term. Even though optimal capital
structure is considered critical in facilitating the financial performance, limited financial
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Henry Mugisha, Job Omagwa, James Kilika 39
capacity has also been faulted for hampering day-to-day operations and eventual
growth of SMEs (Fowowe, 2017; Klonowski, 2012).
Theoretically, the financial performance of firms is explained by the relationship
between the agents and the shareholders, as espoused by the agency theory. According
to Jensen and Meckling (1976), managers tend to pursue self-interests instead of the
profit maximization goals of the shareholders, as attainment of the shareholder goals
requires managers to control self-seeking behavior. Measures to mitigate the agency
conflict have been prescribed by the free cash flow theory (Jensen, 1986). The theory
posits that, for firms that have excess resources relative to the amounts required for
investment, debt obligations become a better way to resolve the agency conflicts linked
to free cash. Jensen (1986) further argues that, since the executives are responsible for
the obligations of the firm, periodic payment of interest and the principal amount limits
the availability of the unapplied excess cash that would be invested in activities that are
not beneficial to the shareholders.
Capital structure refers to a combination of various proportions of debt (e.g.,
short-term debt, long-term debt) and owner(s)’ funds a firm uses to finance its
operations and acquire assets (Brigham & Ehrhardt, 2013). SMEs, as well as large firms,
are often faced with a dilemma regarding the amount of debt and equity they should
adopt in financing their operations in the attempt to optimize performance. However,
debt remains the major source of financing for SMEs regardless of the accessibility
problem. Abbasi et al. (2017) argue that, in addition to the availability of debt facilities,
the approval requirements for obtaining equity finance from the stock exchange
markets are an obstacle for SMEs. Consequently, debt continues to be the most
available source of financing for SMEs that usually borrow from non-formal lending
institutions (Wahba, 2013). Obtaining financing from informal lenders is both
theoretically and practically acceptable from the formal lenders’ point of view due to
the perceived high risk associated with SME borrowers (Githaiga & Kabiru, 2015).
SMEs in Uganda represent business establishments that generate an annual
sales revenue ranging between 10 and 99 million UGX, and employing 5 to 49 full-time
employees for small firms, and 100 to 360 million UGX and employing 50 to 100
employees for medium enterprises (Uganda Investment Authority, 2016).
According to Competitive Industries and Innovation Program (2016), the formal
financial sector had been reluctant to extend credit to SMEs, citing issues of a
dysfunctional credit market characterized by incomplete or absent financial information
about the SMEs. The World Bank Enterprise Survey (2013) further indicates that lack of
access to credit remains the greatest obstacle for SMEs in Uganda. Accordingly, Ugandan
SMEs primarily rely on informal sources of finance characterized by stringent conditions
for loan accessibility. Indeed, Eton et al. (2017) observed that the major sources of SME
financing include personal savings, retained profits, contributions from business
partners or shareholders (for limited companies), and loans from friends and relatives,
as well as trade credit from suppliers, money lenders, and to a lesser extent formal
financial institutions (especially for the medium-scale firms).
In view of the foregoing, the study aimed at investigating the mediating effect
of financial capacity in the relationship between capital structure and financial
performance of SMEs in Buganda region, Uganda. Capital structure is measured by the
level of short-term debt, long-term debt and equity capital, while financial capacity is
represented by liquidity and solvency. Financial performance is measured by return on
assets. The study provides evidence that financial capacity has a partial and significant
effect in the relationship between capital structure and financial performance of SMEs
in Buganda region.
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Henry Mugisha, Job Omagwa, James Kilika 40
Financial performance is a key factor influencing the sustainability and long-
term survival of SMEs because financial growth is a critical source of financing for
recurrent operations as well as long-term investments (Mirza & Javed, 2013; Musah &
Kong, 2019). To deliver inclusive sustainable economic development, SMEs must make
appropriate financing decisions as they pursue financial sustainability necessary for
sustained economic growth (Organisation for Economic Cooperation and Development,
2017; World Trade Organisation, 2016).
Thus, when their financial performance declines, SMEs cannot sustain growth
necessary for the achievement of their broader economic development mandate
(Nikolić et al., 2019). For instance, a World Bank report on Uganda (2017) indicated that
69% of SMEs in the Kampala metropolitan area generate less than 10 million Uganda
shillings annually in net income, rendering them too unprofitable for tax and business
growth purposes. Evidence provided by Uganda Investment Authority (2018) further
indicates that, 70% of the businesses do not survive until their 3rd year of establishment,
making a sharp decline compared to 50% reported by Walter et al. (2004) only 14 years
earlier. The Competitive Industries and Innovation Program (2016) attributes this issue
to a decline in credit growth from 60% in 2013 to less than 10% in 2016 for the major
sectors of the economy. As credit growth is a reflection of profitability in an economy, it
inevitably affects the SME sector. However, the extent to which the poor performance
trend is linked to the capital structure of SMEs remains an empirically unresolved
challenge.
In the extant literature, financial performance challenges are typically linked to
capital structure decisions. However, most empirical research has focused on the direct
effects, with little regard to the effects of the mediating variables in the capital
structure−financial performance relationship. Helm and Antje (2012) argue that, due to
the failure to include mediation factors, business research models continue to generate
not only contradictory results but also results that do not address the practical realities
of business practice. Empirical evidence further indicates that financial capacity
represented by liquidity and solvency is critical to the performance of small and
medium-sized firms (Fowowe, 2017). Still, while literature about the direct effect of
capital structure on financial performance abounds, there is paucity of empirical studies
to support the mediating effect of financial capacity in the capital structure−financial
performance relationship, especially those conducted in the emerging economy
contexts such as Uganda.
Further, findings reported in extant literature on the relationship between
capital structure and financial performance are inconsistent (Abor, 2005; Khan, 2012).
For instance, Harash et al. (2014) and Cheruyot and Ntoiti (2015) established that both
short-term and long-term debt reduced financial performance measured by return on
assets. Wahba (2013) and Eton et al. (2017) similarly reported a positive relationship
between debt and return on assets as a proxy of financial performance. In an earlier
study, however, Ebaid (2009) found no significant impact of short-term or long-term
debt on financial performance measured by return on equity and gross profit margin.
According to Helm and Antje (2012), these inconsistencies are mainly driven by
methodological concerns including failure to consider mediation effects in the
relationship.
Although it is possible to collect data on the mediating variables, this is rarely
done in empirical finance studies, especially those focusing on SMEs. Mohammad and
Navida-Reza (2016) assert that without identifying the hidden variables such as
mediating factors in finance research, the resultant models will not be capable of
addressing actual business problems. It is thus evident that the empirical as well as
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Henry Mugisha, Job Omagwa, James Kilika 41
contextual gaps exist in pertinent literature, motivating the present study. In particular,
the aim of this work is to close the knowledge gap related to the mediating effect of
financial capacity in the relationship between capital structure and financial
performance of SMEs.
Therefore, the objective of the study was to determine the mediating effect of
financial capacity in the relationship between capital structure and financial
performance of SMEs in the Buganda region, Uganda.
2. Literature Review and Hypothesis Development
This study is anchored on theoretical propositions as well as findings of previous
research as discussed in this section. The section concludes with a study hypothesis
arising from the literature reviewed.
2.1 Theoretical Review
Scientific research relies on theories advanced in the identified field of study to
explain and predict phenomena to permit generalizations (Rengasamy, 2016). Theories
are furthermore used as a basis for supporting intellectual arguments but can also be
used to question external extant knowledge within limits of critical bounding
conventions (Tavallaei & Talib, 2010). Accordingly, this paper is anchored on the agency
and free cashflow theories.
2.1.1 The agency theory
The agency theory developed by Jensen and Meckling (1976) pertains to the
relationship between the equity holders and the managing executives of a corporate
body. This theory explains the way firms shape relationships in which the principal
decides on what the agent ought to do, supposedly in the best interest of the principal.
Its key assumption is that rational individuals act in self-interest. Citing Jensen and
Meckling (1976), Huang et al. (2016) posit that, according to the agency theory,
executives are self-oriented in defining the goals of an entity which deviates from the
expectations of the equity holders. The authors further argue that, if the self-seeking
behavior of the executives is not controlled, they are more likely to invest in negative
net income projects in contravention of the wealth maximization goal of the equity
holders.
Findings reported in the empirical finance literature also indicate that, while the
shareholders are motivated by maximization of their wealth through profit
reinvestment, the managers are interested in maximizing their welfare by applying any
excess resources into non-profit making activities at the expense of the shareholder
wealth maximization goal. Yahya et al. (2016) argue that the principal−agent collision of
interest leads to the agency conflict, which fundamentally undermines the achievement
of the strategic financial performance growth goal of a business. Panda and Leepsa
(2017) similarly indicate that reducing the agency conflict involves increasing investment
capital through debt to limit the excess resources available to the managers. The authors
justify this view by noting that, because the managers have the responsibility of servicing
the debt, they will be obligated to apply the excess resources to the payment of interest
and principal, thereby working in the interest of the shareholders.
Although this argument holds for limited companies, most SMEs operate
informally, with key decisions made by owner-managers. Accordingly, financial capacity,
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Henry Mugisha, Job Omagwa, James Kilika 42
rather than managerial behavior, is their greatest investment challenge. Nonetheless,
the agency theory is still pertinent for the current investigation because it justifies the
role of short- and long-term debt in resolving the agency problem in growth-oriented
SMEs. Empirical evidence indicates that incorporation of debt in the capital structure
controls the underinvestment problem by managers (Yahya et al., 2016).
2.1.2 Free cash flow theory
Free cash flow refers to the cash resources over and above the amount needed
to finance approved investment activities considered to possess a positive net present
value (Zurigat et al., 2014). The free cash flow theory was proposed by Jensen (1986),
who argued that, for firms that are more likely to have high amounts of excess funds but
without apparent investment opportunities, debt becomes an efficient way of resolving
the agency costs associated with free cash flow. The author supported this assertion by
the fact that debt generates an obligation for payment of interest and part of the
principal at regular intervals, which is the responsibility of the managers (Jensen, 1986).
Accordingly, because of the obligation the managers have to the creditors, the free cash
flow becomes unavailable for investment in resource-wasting projects thereby
effectively mitigating the agency problem and forcing firms to perform in the interest of
shareholders.
Hau (2017) studied the free cash flow and performance of Vietnamese listed
firms and reported a positive association between free cash flow and company
performance in all sectors covered by the study. However, the relationship was different
for companies with poor investment opportunities. This finding concurs with Jensen's
(1986) view that businesses with high amounts of free cash flow but with low levels of
investment opportunities will provide the managers with a leeway to apply the excess
funds to projects not beneficial to the shareholders, leading to poor firm performance.
2.2 Empirical review
2.2.1 Capital structure and financial performance
Firms’ choice of financing options has been linked to their financial
performance, as measured by various components of capital structure (short-term debt,
long-term debt, and equity capital). Short-term debt is commended for availing liquidity
in times of financial crises, as well as mitigating the agency conflict between the
managers and the equity holders. For instance, several authors have reported a positive
relationship between short-term debt ratio and return on equity on financial
performance (Abor, 2005; Adesina et al., 2015). On the other hand, others have
indicated that short-term debt does not enhance financial performance of SMEs. For
instance, in their study on the agency theory of capital structure and firm performance
in India, Dawar (2014) noted a negative relationship between short-term debt and
financial performance using a return on assets and return on equity as proxies for
financial performance, while Ebaid (2009) and Chadha and Sharma (2015) reported
weak or nonexistent impact. A negative capital structure−financial performance link has
been established in many other studies (Akeem et al., 2014; Khan, 2012; Nassar, 2016).
In extant research, however, long-term debt is linked to a number of benefits
for SMEs, including controlling the managerial discretion as well as the positive impact
on financial performance attributed to the associated debt interest and tax shield
benefits (Badar & Saeed, 2013; Korzh, 2015; Wahba, 2013). Furthermore, long-term
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Henry Mugisha, Job Omagwa, James Kilika 43
debt is commended for improving the productive capacity of the firm by availing
resources for investment in long-term projects. According to Zoghi (2017), increased
productivity provides a cushion against risk rollover vulnerability, which is common in
SMEs. Conversely, Asare and Angmor (2015) and Admassu (2016) argued that excessive
long-term debt could result in distortions in the risk preferences of the shareholders,
while limiting debt accessibility due to the increased cost of debt, which could impact
negatively on the financial performance of SMEs.
Other authors that have explored various financing options available to SMEs
have indicated that equity capital forms the most reliable source of SME funding. They
justify this assertion with the fact that equity capital is collateral free, facilitates long-
term investments, and attracts no covenants with those who provide it (Divakaran et al.,
2014; Pettit & Singer, 1985). However, the findings related to the link between equity
capital and financial performance are inconsistent. For instance, while Cheruyot and
Ntoiti (2015) as well as Nasimi (2016) established a negative and significant relationship
between equity and firm performance, Taani (2013), Vatavua (2015), as well as Muturi
and Njeru (2019) reported a significant and positive association with all the identified
measures of financial performance.
2.2.2 Mediating effect of financial capacity and Financial Performance
The ability of business organizations to stay afloat during economic downturns
is dependent on their capacity to offset their short-as well as long-term obligations.
Studies show that firms’ inability to settle their obligations as and when they fall due
exposes them to the risk of restructuring as well as bankruptcy, which could hurt their
equity value. Kajananthan and Velnampy (2014) and Srbinoska (2018) maintain that the
performance of a firm is directly but also indirectly linked to its financial capacity.
Accordingly, financial capacity was proxied by liquidity and solvency in the present study
in the attempt to explain its mediation role in the relationship between capital structure
and financial performance of SMEs, as this is a common approach in related studies
(Hau, 2017).
In their study about the mediating effect of leverage in the link between
ownership concentration and firm financial performance, Noghondari and Noghondari
(2017) assessed the mediating effect of leverage on firm performance. The authors
obtained relevant data from a census of publicly traded companies in Tehran. Their
multiple regression analysis results indicated a full mediation effect of financial leverage
in the ownership concentration−business performance relationship of the listed
business entities in Tehran. However, the authors focused on long-term debt and
ignored the contribution of short-term debt in the effect of leverage in the capital
structure−financial performance relationship.
Ibrahim et al. (2015) studied the mediating role of cash management in the
association between capital structure and liquidity of SMEs in Jameta, Adamawa state
in Nigeria. Their objective was to elucidate the mediating influence of cash management
in the relationship between capital structure and liquidity by analyzing the responses
provided by 366 survey respondents. Their findings indicated a partial mediation effect
of cash management in the link between capital structure and liquidity. However, as the
study was conducted in a small geographical location, its findings cannot be generalized
beyond this specific setting. This issue is addressed in the present study by focusing on
a large region in the central part of Uganda.
Shahwan (2018) investigated the mediating effect of financing and investment
decisions on the impact of capital structure on corporate performance in Jordan. For this
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Henry Mugisha, Job Omagwa, James Kilika 44
purpose, the author analyzed data provided in the financial reports of the banks listed
on the Amman Stock Exchange during the 2002−2017 period. The regression results
indicated a partial mediation effect for both financing and investment decisions in the
relationship. As in such models the mediating variables should be highly correlated with
the independent variable, while the two must not be similar (Mackinnon et al., 2007), in
the present study, focus is given to the financing decisions that are in effect the
components of capital structure (debt and/or equity). Thus, mediating variables are
clearly distinguished from the independent variables.
Nazir et al. (2010) studied the role played by dividend policy in determining the
changes in stock prices in Pakistan by analyzing the data pertaining to 73 firms quoted
on the Karachi Stock Exchange spanning the 2003−2008 period. The panel data
regression analysis using both fixed and random effects models indicated a full
mediating effect of the dividend policy in the relationship between stock price volatility
and dividend yield as well as dividend payout ratio.
Angeles et al. (2019) investigated microfinancing as a mediator in the
relationship between access to finance and microenterprise success focusing on the
microbusinesses in the Philippines. The authors adopted a causal research design using
a quantitative approach, and analyzed data pertaining to 582 microbusinesses that was
sourced from a public database. The mediation analysis indicated that microfinance had
a full mediation effect in the association between access to finance and microenterprise
growth. However, the mediating variable was generalized even though microfinance
exists in various forms with divergent options of services (Brau & Woller, 2004). These
drawbacks are mitigated in the present study by conceptualizing the mediating variable
(financial capacity) in such a way that its major components (liquidity and solvency)
could be identified and their contribution to the relationship demonstrated.
In light of the evidence presented above, it is apparent that the available
findings regarding both direct and mediated relationship between capital structure and
financial performance remain inconclusive. Additionally, extant literature indicates that
the financial capacity of a firm is a critical driver of its financial performance (Fonseka et
al., 2014). While literature focusing on the direct link between capital structure and
financial performance abounds, studies explaining the mediating effect of financial
capacity represented by liquidity and solvency are still relatively rare. Accordingly, the
following hypothesis is tested in the present study:
H0: Financial capacity does not have a significant mediation effect in the relationship
between capital structure and financial performance of small and medium-scale
enterprises in the Buganda region, Uganda.
3. Methodology and Data
3.1 Research Design
The research design describes how an investigation aimed at answering
research questions is to be carried out (Saunders et al., 2012). The present study was
based on a descriptive cross-sectional research design because its aim was to test
relationships between variables representing the phenomenon of interest using data
related to a specific sample and point in time, as suggested by Creswell (2014).
3.2 Study Context, Population, and Sample
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Henry Mugisha, Job Omagwa, James Kilika 45
The present study focused on SMEs in the Buganda region, Uganda. This
investigation focused on SMEs because they contribute 20% to the Ugandan GDP but
have 50% failure rate (Abaho et al., 2017). The choice of the Buganda region was
informed by several factors, including large concentration of registered SMEs (59.2% of
all SMEs operating in the country), convenient accessibility of the study area, and
relatively better infrastructure relative to other regions of Uganda. The 2014−2019
period was chosen, as it coincided with a particularly unfavorable business environment
for most SMEs in Uganda, as reflected by the country’s global rating of 166/189 and high
business failure rate.
Moreover, the study sample was drawn from 133,454 SMEs operating within
the Kampala metropolitan area, representing 61.1% of the SMEs in the Buganda region
(Ministry of Trade, Industry, and Cooperatives, 2015). Sampling was conducted at two
levels. Stratified sampling approach was applied in selecting SMEs, from which one
respondent was chosen using the purposive approach. In accordance with the strategy
proposed by Yamane (1967), a sample size of 399 was determined. However, as 12%
non-response rate was established at the pre-test stage of the questionnaire, as
suggested by Mac Kenzie (2005), the final sample size was increased to 453 (Mellahi &
Harris, 2016), in accordance with the calculation presented below:
Final sample size = calculated sample size
1−expected nonresponse rate = 399
1−0.12= 453 respondents
However, only 423 valid questionnaires were returned, therefore represented the final
sample retained for analysis.
3.3 Data Collection and Analysis
The data for this study was obtained via a survey. For this purpose, a
questionnaire was developed, requiring responses on a 5-point Likert scale to facilitate
quantification of participants’ views as suggested by Kwiecinski (2017 and Tomaskova
(2009). Data was subjected to descriptive analysis using means, percentages, and
standard deviations, as well as multiple regression analysis.
3.4 Empirical Model: Mediation Effect of Financial Capacity
The mediation effect was estimated using financial capacity as a mediator
variable proxied by liquidity and solvency, as proposed by Baron and Kenny (1986). In
addition, other firm-level factors were controlled for by adopting the five-step
mediation procedure following the work of Mathieu and Taylor (2006), cited in
Noghondari and Noghondari (2017).
In the first step, the dependent variable “Financial performance” (FP) measured
by ROA was regressed on the control variables (years in business, workforce size, type
of ownership, and business sector of firm) without considering the independent variable
in order to determine the pure impact of control variables on the dependent variable.
FP = β0 + β1 (Yr) + β2(Size) + β3(Own) + β4(Sector) + ε….…………Model 1
Where:
FP = Financial performance
Yr = Years in business
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Henry Mugisha, Job Omagwa, James Kilika 46
Size = Workforce size
Own =Type of business ownership (1 = Sole; 2 = Partnership; 3 = Limited)
Sector = Business sector (1 = Services; 2 = Manufacturing; 3 = Agribusiness; 4 = Other)
β0 = A constant
β1, β2, β3, β4 = Regression coefficients
ε = Error term
In the second step, the independent variable (capital structure) was added into Model
1 to capture the direct effect of capital structure on financial performance.
FP = β0 + β1(Yr) + β2(Size) + β3(Own) + β4(Sector) + β5(CS) + ε….…………Model 2
Where CS = capital structure
The rest of the abbreviations are as defined in model 1 above
In the third and fourth model, the dependent variable was the mediating
variable (Financial capacity) measured by liquidity and solvency. The third model
examines the impact of control variables on financial capacity excluding the
independent variable of capital structure.
FC = β0 + β1(Yr) + β2(Size) + β3(Own) + β4(Sector) + ε….…………Model 3
Where: FC = Financial Capacity
The fourth model examines the impact of control variables and the independent variable
(Capital structure) on financial capacity. Model 4 is represented by path a in the
mediation effect framework below.
FC = β0 + β1(Yr) + β2(Size) + β3(Own) + β4(Sector) + β5(CS) + ε…. Model 4
Where: FC = Financial Capacity
The rest of the abbreviations are as defined in model 1 above
In step five, the dependent variable (Financial performance) was regressed on
the independent variable (Capital structure) along with the mediating variable (Financial
capacity), as well as the control variables, to determine whether capital structure
predicts financial performance. Model 5 shows the mediation effect of financial capacity
(path c') as well as the impact of financial capacity (path b) on financial performance.
The full mediation effect would exist if the effect of capital structure on financial
performance—while controlling for the mediator and other control variables—would
decrease to zero. However, if the relationship between capital structure and financial
performance would significantly deviate from zero, a partial mediation effect would be
considered to exist (Baron & Kenny, 1986), cited in Mehmetoglu (2018). Figure 1 depicts
the mediation effect requirements.
FP = β0 + β1 (Yr) +β2(Size) + β3(Own) + β4(Sector) + β5(CS) + β6(FC) + ε…. Model 5
FC
Finance, Markets and Valuation Vol. 8, Num. 2 (July-December 2022), 37–57
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Henry Mugisha, Job Omagwa, James Kilika 47
a b
c
c'
Figure 1. Mediation effect framework.
Source: Modified from Andrew and Hayes (2009).
Where:
CS = capital structure
FC = Financial capacity
FP = Financial performance
Whether the outcome of the mediation analysis is partial or complete mediation
depends on whether path c representing the direct effect between the variables is
statistically significant (indicating partial mediation) or not (indicating complete
mediation) (Hayes, 2009; Mathieu & Taylor, 2006), cited in Noghondari and Noghondari
(2017).
4. Results and Discussion
4.1 Characteristics of the Small and Medium Enterprises
The characteristics of the enterprises that participated in the study are
presented in Table 1.
Table 1. Sample distribution by ownership structure and business sector of the SMEs
Ownership structure
Freq.
Percent
Sole proprietorship
73
17.3
Partnership
110
26.0
Private limited company
240
56.7
Sector of business operation
Services
156
36.9
Manufacturing
177
41.8
Agribusiness
80
18.9
Other
10
2.4
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Henry Mugisha, Job Omagwa, James Kilika 48
Source: Survey data, 2019
As can be seen from Table 1, majority of the SMEs that participated in the study
were private limited companies, followed by partnership businesses and sole
proprietorships. Based on the sector of operation, majority of SMEs were in the
manufacturing sector, followed by the services sector.
According to the World Bank Group (2013), the sole proprietorship businesses formed
the majority (65%) of the micro, small and medium scale enterprises in Uganda, while
partnership businesses and limited companies contributed by 23.7% and 11%,
respectively. These differences are attributed to the focus on SMEs operating in the
Buganda region of Uganda in this study, while the World Bank study also included micro
and large enterprises and extended to the entire country.
4.2 Descriptive Analysis
4.2.1 Descriptive results for short-term debt, long-term debt, and financial capacity
This section presents the descriptive analysis for the capital structure variable
(STD, LTD, and equity capital) as well as the mediating variable (financial capacity)
represented by liquidity and solvency. The descriptive statistics are obtained from the
computed additive indices that capture participants’ questionnaire responses. The results
are presented in Table 2.
Table 2. Descriptive Analysis of the variables
Variable
Mean
Std
Dev.
Median
Max
Min
Capital
structure
STD
16.3
7.5
15
35
7
LTD
14.5
5.7
14
29
6
Equity
17.2
4.3
17
29
6
Overall (capital
structure)
48.0
15.6
44
88
22
Financial
capacity
Liquidity
26.0
4.7
26
35
7
Solvency
16.1
4.6
17
25
5
Overall (financial
capacity)
42.1
8.0
43
60
12
Financial
performance
Return on Assets
21.7
4.4
22
30
6
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Henry Mugisha, Job Omagwa, James Kilika 49
Source: Survey data, 2019
From Table 2, it is evident that, on average, the respondents agreed with the
statements about capital structure, financial capacity, and performance of SMEs.
Moreover, on average, the SMEs in focus of this study had adequate short-term
resources (liquidity) to offset day-to-day obligations and were profitable in terms of
return on assets.
4.2.2 Hypothesis testing: Mediating effect of financial capacity
For testing the hypothesis guiding this study, the five-step procedure described by
Noghondari and Noghondari (2017) was adopted. The aim was to determine if the
previously established mediation results will persist after controlling for firm-specific
characteristics. The results are presented in Table 3.
Table 3. Regression analysis results for mediation effects of financial capacity
Model 1
Model 2
Model 3
Model 4
Model 5
VARIABLES
ROA
ROA
FC
FC
ROA
Years in business
-0.0256
-0.0292
0.0562
0.0584
-0.0527***
-0.0234
-0.023
-0.0386
-0.0388
-0.0163
Workforce size
0.0292***
0.0333***
0.0652***
0.0627***
0.00815
-0.0102
-0.01
-0.0191
-0.0196
-0.00662
Ownership Type
(Base: Sole
ownership)
Partnership
0.022
0.892
3.677***
3.155**
-0.376
-0.672
-0.793
-1.256
-1.371
-0.597
Private Limited
1.446**
1.117*
4.157***
4.355***
-0.634
-0.6
-0.603
-1.104
-1.143
-0.475
Business Sector
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Henry Mugisha, Job Omagwa, James Kilika 50
(Base: Services)
Manufacturing
-0.397
-0.304
-0.205
-0.261
-0.199
-0.49
-0.484
-0.845
-0.851
-0.334
Agribusiness
-1.151**
-1.191**
-1.933*
-1.909*
-0.424
-0.585
-0.591
-1.074
-1.065
-0.41
Other
-3.075
-3.843*
-11.06***
-10.60***
0.417
-2.135
-2.075
-2.529
-2.569
-2.105
Capital structure
-0.0486**
0.0292
-0.0603***
-0.0192
-0.035
-0.0136
Financial capacity
0.402***
-0.0217
Constant
20.99***
23.23***
37.08***
35.74***
8.865***
-0.612
-1.051
-1.213
-1.999
-1.126
Observations
423
423
423
423
423
R-squared
0.069
0.085
0.151
0.153
0.525
Notes: *** p < 0.01, ** p < 0.05, * p < 0.1; Robust standard errors are given in parentheses
Source: Survey data, 2019
From the Model 1 results reported in Table 3, it is evident that there is a positive
and significant relationship (p < 0.01, β = 0.0292) between the control variable “Firm
size” represented by number of employees and the dependent variable “Financial
performance” represented by return on assets. Model 2 results further indicate that
there is a significant negative relationship (β = -0.0486, p < 0.05) between capital
structure and financial performance of SMEs. Therefore, path c is significant.
Model 3 pertains to the relationship between the mediator variable “Financial capacity”
and the control variable “Firm size” measured by workforce size. Accordingly, the results
show that firm size—measured by number of employees, ownership type, and business
sector—is significantly related to financial capacity. In addition, the results of Model 4
indicate that the relationship between capital structure and financial capacity is not
significant (β = 0.0292, p < 0.05). Therefore, path a is not significant.
According to the results yielded by Model 5, the independent variable “Capital
structure” reveals a negative and statistically significant relationship with financial
performance (β = -0.0603, p < 0.01). Therefore, path c' is significant. However, Model 5
results also indicate that the relationship between the mediator variable “Financial
capacity” and the dependent variable “Financial performance” is significant (β = 0.402,
p < 0.05). Therefore, path b is significant. The fact that path c is significant implies that
financial capacity is a partial mediator of the relationship between capital structure and
financial performance. Accordingly, the hypothesis that financial capacity does not have
a significant mediation effect in the relationship between capital structure and financial
performance is rejected.
This finding is consistent with that reported in other studies. For instance,
Noghondari and Noghondari (2017) recorded a full mediation effect of financial leverage
between ownership and firm performance. Further, Angeles et al. (2019) demonstrated
a full mediation effect of microfinancing between access to funds and microenterprise
growth. Moreover, the current study results indicate a positive relationship between
financial capacity (liquidity and solvency) and financial performance, in line with the free
Finance, Markets and Valuation Vol. 8, Num. 2 (July-December 2022), 37–57
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Henry Mugisha, Job Omagwa, James Kilika 51
cash flow theory put forth by Jensen (1986). This theory postulates that, for firms with
excess unapplied funds, debt would discourage managers from investing in wasteful and
non-profitable projects because of the debt repayment obligation upon them.
Accordingly, the managers would be obliged to avoid resource-wasting projects and
invest in profitable ventures to realize enough liquidity to offset the debt obligations,
leading to better performance.
5. Conclusions and Implications
The present study contributes to the finance literature in a number of ways.
From the empirical perspective, its main value stems from documenting the mediation
effect in the capital structure−financial performance relationship in SMEs. Previous
studies have largely focused on a direct relationship, resulting in a limited knowledge on
the influence of non-firm characteristics in the capital structure−financial performance
relationship. Moreover, the findings obtained in this study have theoretical implications,
as they confirm the utility of specific theories in empirical research in the SME context.
For instance, the fact that fewer SMEs indicated debt (short-term and long-term) as the
preferred financing option relative to equity capital confirms the propositions of the
pecking order theory. Moreover, the finding that financial capacity significantly affects
the relationship between capital structure and financial performance is consistent with
the postulations of the free cash flow theory. Finally, the present study contributes to
practice by documenting the effect of the mediating variable in the capital
structure−financial performance relationship, thus providing an important foundation
for accurate capital structure decisions in small and medium scale enterprises.
According to the responses obtained in the survey, the hypothesis that was
tested as a part of the present study was rejected, as financial capacity (as measured by
liquidity and financial solvency) has a partial and significant mediation effect in the
relationship between capital structure and financial performance of SMEs. This finding
demonstrates that the variations in financial performance are explained by the influence
of financial capacity on the capital structure−financial performance relationship.
Therefore, the financial performance of SMEs would can be improved by maintaining
optimal levels of liquidity and financial solvency.
As a way practical implication, the study recommends that operators of SMEs
should consider the effect of mediator factors while deciding the financing mix to
optimize the performance of their firms. Finally, the current study was not devoid of
limitations. Worth noting, was the inadequacy of financial data necessitated reliance on
the data obtained through questionnaires. Being a cross sectional study, it was also
difficult to establish performance trends of SMEs over a reasonably longer period.
Accordingly, future studies should focus on time series data to explain the mediating
effect of financial capacity in the link between capital structure and financial
performance.
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