LEVERAGE AND PROFITABILITY OF LISTED HEALTHCARE FIRMS IN NIGERIA

CHAPTER ONE: INTRODUCTION

1.1 Background to the Study

Leverage refers to the use of borrowed funds (debt) to finance a firm’s assets and operations. It is a critical financial decision that affects a firm’s risk profile, cost of capital, and profitability. Leverage can be measured in several ways: (a) debt ratio – total liabilities divided by total assets, (b) debt-to-equity ratio – total liabilities divided by shareholders’ equity, (c) long-term debt ratio – long-term debt divided by total assets, and (d) interest coverage ratio – earnings before interest and taxes (EBIT) divided by interest expense. The use of leverage magnifies both returns and risks; when a firm earns more on borrowed funds than it pays in interest, leverage increases profitability (positive leverage). When returns are lower than interest costs, leverage reduces profitability (negative leverage) (Brigham and Ehrhardt, 2017; Ross, Westerfield, and Jordan, 2019).

The relationship between leverage and profitability has been extensively studied in corporate finance, with conflicting theoretical predictions and empirical results. According to the trade-off theory, firms balance the tax benefits of debt (interest payments are tax-deductible) against the costs of financial distress (bankruptcy risk, agency costs). Firms with high profitability may use more debt to shield income from taxes (tax shield). According to the pecking order theory, firms prefer internal financing (retained earnings) over debt, and debt over equity. Highly profitable firms generate more internal funds and therefore use less debt (negative relationship between leverage and profitability). According to the agency theory, debt can reduce agency costs by disciplining managers (free cash flow hypothesis), but excessive debt may lead to underinvestment (Myers, 1977; Jensen and Meckling, 1976; Myers and Majluf, 1984).

The healthcare industry has unique characteristics that affect the leverage-profitability relationship. Healthcare firms (hospitals, diagnostic centers, pharmaceutical manufacturers, medical equipment suppliers, healthcare service providers) face: (a) high capital intensity – significant investment in medical equipment, facilities, and technology, (b) regulatory environment – compliance with health regulations, licensing, and quality standards, (c) reimbursement uncertainty – delays in payments from government health programs and insurance companies, (d) technological change – rapid obsolescence of medical equipment, requiring continuous investment, (e) working capital needs – inventory of drugs and medical supplies, accounts receivable from patients and insurers, and (f) seasonality – demand fluctuations based on disease outbreaks (e.g., malaria season) (World Bank, 2018; Adebayo and Oyedokun, 2019).

The Nigerian healthcare industry has grown significantly in recent years, driven by: (a) increasing population, (b) rising prevalence of chronic diseases (diabetes, hypertension, cancer), (c) expansion of health insurance (National Health Insurance Scheme, private health insurers), (d) government investment in healthcare infrastructure, (e) emergence of private healthcare providers and medical tourism (Nigerians traveling abroad for treatment), and (f) the impact of the COVID-19 pandemic highlighting the importance of healthcare infrastructure. Listed healthcare firms in Nigeria are companies engaged in healthcare services, pharmaceutical manufacturing, medical equipment supply, and related activities, listed on the Nigerian Exchange Limited (NGX). These firms include hospitals (e.g., Nisa Premier Hospital), pharmaceutical manufacturers (e.g., Fidson Healthcare, May and Baker), and other healthcare-related companies (Nigeria Exchange Group, 2022; CBN, 2021).

Profitability is a primary measure of firm performance and is typically measured using: (a) return on assets (ROA) – net profit divided by total assets, (b) return on equity (ROE) – net profit divided by shareholders’ equity, (c) gross profit margin – gross profit divided by revenue, (d) operating profit margin – operating profit divided by revenue, and (e) net profit margin – net profit divided by revenue. For healthcare firms, profitability is affected by: (a) patient volume and service mix, (b) reimbursement rates from insurers and government, (c) cost of drugs and medical supplies, (d) labor costs (physicians, nurses, technicians), (e) occupancy rates and capacity utilization, (f) technology investment, and (g) competition (Brigham and Ehrhardt, 2017; Penman, 2018).

The theoretical relationship between leverage and profitability can be analyzed through several lenses. The trade-off theory predicts a positive relationship between leverage and profitability (profitable firms use more debt for tax shields). The pecking order theory predicts a negative relationship (profitable firms use retained earnings, reducing debt). The signaling theory suggests that firms with high leverage signal confidence in future profitability (Ross, 1977). The agency theory suggests that debt can reduce agency costs (free cash flow hypothesis), potentially improving profitability (Jensen, 1986). In emerging markets like Nigeria, where capital markets are less developed and information asymmetry is high, the pecking order theory may dominate, predicting a negative relationship between leverage and profitability (Okafor and Udeh, 2020).

Empirical studies on the leverage-profitability relationship in Nigeria have produced mixed results. Some studies have found a negative relationship (higher leverage reduces profitability), consistent with the pecking order theory. Others have found a positive relationship (higher leverage increases profitability), consistent with the trade-off theory. The relationship may vary by industry, firm size, and time period. For the healthcare industry specifically, limited research is available. Healthcare firms may have unique capital structures due to high capital intensity and regulatory constraints. Understanding the leverage-profitability relationship for listed healthcare firms in Nigeria is important for: (a) financial managers making capital structure decisions, (b) investors assessing firm risk and return, (c) creditors evaluating creditworthiness, (d) regulators monitoring financial stability, and (e) policymakers supporting healthcare sector growth (Adebayo and Oyedokun, 2020; Eze and Nwafor, 2019).

The healthcare sector in Nigeria faces significant funding challenges. Many healthcare firms rely on debt financing (bank loans, equipment leasing, supplier credit) to fund capital expenditures (medical equipment, facilities expansion) and working capital (drug inventory, accounts receivable). However, high interest rates (often 15-25% per annum), short loan tenors, and collateral requirements constrain access to debt. Alternative financing sources include equity financing (rights issues, public offerings) and development finance institutions. The capital structure decision (mix of debt and equity) affects the firm’s cost of capital, risk, and profitability. For listed healthcare firms, access to equity markets provides an alternative to debt financing (CBN, 2021; Okafor and Udeh, 2021).

The Nigerian healthcare industry has specific leverage characteristics. Hospital groups may have high fixed assets (land, buildings, medical equipment) that can be used as collateral for debt, potentially enabling higher leverage. Pharmaceutical manufacturers may have significant working capital needs (inventory of raw materials and finished goods, accounts receivable from distributors and hospitals), leading to higher short-term debt. Diagnostic centers may have high equipment costs (MRI, CT scanners) financed through equipment leasing or bank loans. The optimal capital structure may vary across healthcare subsectors (World Bank, 2018; Adebayo and Oyedokun, 2019).

The impact of leverage on profitability can be analyzed through the DuPont framework. ROA = Net Profit Margin × Asset Turnover. Leverage affects ROA through: (a) interest expense – debt increases interest expense, reducing net profit margin, (b) tax shield – interest is tax-deductible, reducing tax expense, partially offsetting the interest cost, (c) asset base – debt-financed assets increase total assets (denominator of ROA), potentially reducing ROA even if net profit increases. ROE = ROA × Equity Multiplier (Total Assets/Equity). Leverage increases the equity multiplier, magnifying ROE when ROA is positive (favorable) and magnifying losses when ROA is negative (unfavorable) (Brigham and Ehrhardt, 2017; Penman, 2018).

The COVID-19 pandemic had a significant impact on healthcare firms in Nigeria. Demand for healthcare services increased (testing, treatment, vaccination), but supply chain disruptions increased costs, and reimbursement delays affected cash flow. Many healthcare firms increased leverage to fund pandemic response (buying PPE, ventilators, expanding ICU capacity). The post-pandemic period offers an opportunity to assess how increased leverage affected profitability (CBN, 2021; World Bank, 2022).

Finally, this study focuses on listed healthcare firms in Nigeria because they are publicly traded, with available financial data, and represent a significant segment of the healthcare industry. By examining the relationship between leverage and profitability for these firms, the study can provide insights applicable to other healthcare firms and contribute to the literature on capital structure in emerging markets (Yin, 2018; Creswell and Creswell, 2018).

1.2 Statement of the Problem

Listed healthcare firms in Nigeria face significant capital structure decisions that affect their profitability and long-term viability. The healthcare industry is capital-intensive, requiring substantial investment in medical equipment, facilities, technology, and working capital. Firms must decide on the optimal mix of debt and equity financing. However, the relationship between leverage and profitability for Nigerian healthcare firms is not well understood. Theoretical predictions conflict (trade-off theory predicts a positive relationship; pecking order theory predicts a negative relationship). Empirical evidence for Nigerian healthcare firms is limited. Some healthcare firms may be over-leveraged, leading to high interest costs that erode profitability. Others may be under-leveraged, missing opportunities to use debt financing for expansion and tax benefits. External factors such as high interest rates (15-25%), short loan tenors, foreign exchange volatility (affecting imported medical equipment and drugs), and regulatory changes (National Health Insurance Authority Act, 2022) complicate the leverage-profitability relationship. Investors and creditors lack clear guidance on how leverage affects healthcare firm performance. There is a lack of recent, systematic, empirical research that examines the relationship between leverage and profitability for listed healthcare firms in Nigeria. Therefore, this study is motivated to investigate leverage and profitability of listed healthcare firms in Nigeria.

1.3 Objectives of the Study

The specific objectives of this study are to:

1. Examine the leverage levels (debt ratio, debt-to-equity ratio, long-term debt ratio, interest coverage ratio) of listed healthcare firms in Nigeria over the study period.
2. Assess the profitability levels (return on assets ROA, return on equity ROE, net profit margin) of listed healthcare firms in Nigeria over the study period.
3. Determine the relationship between leverage (debt ratio, debt-to-equity ratio) and profitability (ROA, ROE, net profit margin) for listed healthcare firms in Nigeria.
4. Compare the leverage-profitability relationship across healthcare subsectors (hospitals, pharmaceutical manufacturers, diagnostic centers) in Nigeria.
5. Propose recommendations for healthcare firm financial managers, investors, and regulators on optimal capital structure management.

1.4 Statement of Research Hypotheses

The following hypotheses are formulated in null (H₀) and alternative (H₁) forms:

Hypothesis One

• H₀: Leverage (debt ratio) has no significant effect on the return on assets (ROA) of listed healthcare firms in Nigeria.
• H₁: Leverage (debt ratio) has a significant effect on the return on assets (ROA) of listed healthcare firms in Nigeria.

Hypothesis Two

• H₀: There is no significant relationship between debt-to-equity ratio and return on equity (ROE) of listed healthcare firms in Nigeria.
• H₁: There is a significant relationship between debt-to-equity ratio and return on equity (ROE) of listed healthcare firms in Nigeria.

Hypothesis Three

• H₀: Leverage (interest coverage ratio) has no significant effect on the net profit margin of listed healthcare firms in Nigeria.
• H₁: Leverage (interest coverage ratio) has a significant effect on the net profit margin of listed healthcare firms in Nigeria.

Hypothesis Four

• H₀: There is no significant difference in the leverage-profitability relationship between healthcare subsectors (hospitals, pharmaceutical manufacturers, diagnostic centers) in Nigeria.
• H₁: There is a significant difference in the leverage-profitability relationship between healthcare subsectors (hospitals, pharmaceutical manufacturers, diagnostic centers) in Nigeria.

1.5 Scope of the Study

This study focuses on leverage and profitability of listed healthcare firms in Nigeria. Geographically, the research is limited to healthcare firms listed on the Nigerian Exchange Limited (NGX). The study covers all healthcare firms that are publicly traded on the NGX over the period of at least 5 years (e.g., 2019-2023). The healthcare firms include hospitals, pharmaceutical manufacturers, medical equipment suppliers, diagnostic centers, and other healthcare-related companies. Content-wise, the study examines the following variables: leverage measures (debt ratio, debt-to-equity ratio, long-term debt ratio, interest coverage ratio, short-term debt ratio); profitability measures (return on assets ROA, return on equity ROE, gross profit margin, operating profit margin, net profit margin); and control variables (firm size, firm age, asset tangibility, growth, liquidity). The study analyzes secondary data from the annual reports and financial statements of listed healthcare firms. The time frame for data collection is the period 2019-2023 (or longer, depending on data availability). The study does not cover unlisted healthcare firms, nor does it cover non-healthcare firms, nor does it cover healthcare firms in other countries (except for comparative context in the literature review), nor does it cover the operational aspects of healthcare delivery.

1.6 Significance of the Study

This study is significant for several stakeholders. First, financial managers of healthcare firms in Nigeria will benefit from understanding the relationship between leverage and profitability, enabling them to make informed capital structure decisions that optimize profitability while managing risk. Second, investors and financial analysts will gain insights into how leverage affects the financial performance of healthcare firms, supporting investment decisions and valuation. Third, creditors (banks, development finance institutions) will benefit from understanding the risk-return profile of leveraged healthcare firms, informing lending decisions and covenant setting. Fourth, regulators (Nigerian Exchange Group, Securities and Exchange Commission, Federal Ministry of Health) will gain insights into the financial health of listed healthcare firms, informing policy and oversight. Fifth, the National Health Insurance Authority (NHIA) and other healthcare policymakers will benefit from understanding the capital constraints facing healthcare firms, informing reimbursement rates and financing support. Sixth, academics and researchers in corporate finance, healthcare finance, and emerging markets will benefit from the study’s contribution to the literature on capital structure in the healthcare sector. Seventh, professional bodies (ICAN, ANAN, CIBN) will find value in the study’s findings for training and CPD programs. Eighth, healthcare industry associations will benefit from understanding financing challenges, supporting advocacy for improved access to capital. Finally, the broader Nigerian healthcare system will benefit as improved understanding of leverage-profitability relationships leads to better capital allocation, more efficient healthcare delivery, and improved health outcomes.

1.7 Summary

This chapter introduced the study on leverage and profitability of listed healthcare firms in Nigeria. The background discussed the concept of leverage, the healthcare industry’s unique characteristics, the theoretical relationship between leverage and profitability (trade-off theory, pecking order theory, agency theory), and the mixed empirical evidence. The statement of the problem highlighted the lack of research on the leverage-profitability relationship for Nigerian healthcare firms. The objectives of the study were to examine leverage levels, profitability levels, the relationship between leverage and profitability, differences across subsectors, and recommendations. The research hypotheses were formulated to test the significance of the relationships. The scope of the study was defined (listed healthcare firms in Nigeria, 2019-2023). The significance of the study was outlined for financial managers, investors, creditors, regulators, policymakers, academics, and professional bodies.

CHAPTER TWO: LITERATURE REVIEW AND THEORETICAL FRAMEWORK

2.1 Introduction

This chapter reviews the literature relevant to leverage and profitability of listed healthcare firms in Nigeria. The review covers the concept of capital structure, leverage as a component of capital structure, theoretical factors influencing the use of leverage, types and measurement of leverage, the concept of profitability, measurement of profitability, the relationship between leverage and profitability, the theoretical framework underpinning the study, and a summary of the literature. The chapter provides the theoretical and empirical foundation for understanding how leverage affects the profitability of healthcare firms.

2.2 Concept of Capital Structure

Capital structure refers to the mix of debt and equity that a firm uses to finance its assets and operations. It is a fundamental financial decision because it affects the firm’s cost of capital, risk profile, and value. The capital structure decision involves determining the proportion of debt (borrowed funds) and equity (owners’ funds) in the firm’s financing mix. Debt financing includes bank loans, bonds, commercial paper, lease obligations, and other borrowed funds. Equity financing includes common shares, preferred shares, retained earnings, and other owners’ contributions (Brigham and Ehrhardt, 2017; Ross, Westerfield, and Jordan, 2019).

The optimal capital structure is the mix of debt and equity that minimizes the firm’s weighted average cost of capital (WACC) and maximizes its value. The trade-off theory suggests that firms balance the tax benefits of debt (interest tax shield) against the costs of financial distress (bankruptcy costs, agency costs). The pecking order theory suggests that firms prefer internal financing (retained earnings) first, then debt, and finally equity. The market timing theory suggests that firms issue equity when their shares are overvalued and debt when their shares are undervalued (Myers, 1984; Myers and Majluf, 1984).

For healthcare firms, capital structure decisions are influenced by: (a) high capital intensity (investment in medical equipment, facilities), (b) regulatory constraints (capital requirements for hospitals, pharmacy licenses), (c) reimbursement uncertainty (delays in payments from insurers), (d) technological change (rapid obsolescence of medical equipment), and (e) growth opportunities (expansion of facilities, new services). Healthcare firms may have different optimal capital structures than manufacturing or service firms (World Bank, 2018; Adebayo and Oyedokun, 2019).

In Nigeria, healthcare firms have access to various financing sources: (a) bank loans (commercial banks, development banks), (b) equity financing (rights issues, public offerings, private placements), (c) lease financing (equipment leasing, real estate leasing), (d) supplier credit (from pharmaceutical and medical equipment suppliers), (e) government grants and subsidies (for public health programs), and (f) development finance institutions (e.g., Bank of Industry, Development Bank of Nigeria). The availability and cost of these financing sources affect capital structure decisions (CBN, 2021; Okafor and Udeh, 2020).

2.3 Leverage a Component of Capital Structure

Leverage refers to the use of borrowed funds (debt) to finance a firm’s assets. It is a key component of capital structure because it magnifies both returns and risks. Firms use leverage for several reasons: (a) to take advantage of the tax deductibility of interest (tax shield), (b) to increase returns to shareholders (financial leverage magnifies ROE when ROA exceeds the after-tax cost of debt), (c) to avoid dilution of ownership (debt does not dilute ownership, unlike equity), (d) to discipline management (debt reduces free cash flow, limiting managerial discretion), and (e) to signal confidence in future prospects (Ross, 1977; Jensen, 1986).

Leverage can be classified into two types: operating leverage and financial leverage. Operating leverage refers to the use of fixed operating costs (depreciation, rent, salaries) in the firm’s cost structure. High operating leverage means that a small change in sales leads to a large change in operating profit. Financial leverage refers to the use of fixed financial costs (interest on debt) in the firm’s financing structure. High financial leverage means that a small change in operating profit leads to a large change in earnings per share (EPS) and return on equity (ROE). Total leverage is the combination of operating and financial leverage (Brigham and Ehrhardt, 2017).

For healthcare firms, operating leverage is typically high due to significant fixed costs: (a) medical equipment depreciation, (b) facility rent or mortgage payments, (c) salaries of permanent medical staff (physicians, nurses), (d) insurance premiums, and (e) regulatory compliance costs. Financial leverage varies across healthcare firms based on their capital structure choices. Hospitals may have high financial leverage due to large capital investments (buildings, equipment). Pharmaceutical manufacturers may have lower financial leverage due to higher profitability and retained earnings (Okafor and Udeh, 2020).

2.4 Theoretical Factors Influencing the Use of Leverage

Several theoretical factors influence a firm’s decision to use leverage:

Tax Shield: Interest payments on debt are tax-deductible, reducing the firm’s tax liability. The value of the tax shield increases with the corporate tax rate. Firms in higher tax brackets have greater incentive to use debt. In Nigeria, the corporate income tax rate is 30% (plus tertiary education tax), providing a significant tax shield for debt financing (Modigliani and Miller, 1963; Adebayo and Oyedokun, 2020).

Financial Distress Costs: As leverage increases, the probability of financial distress (inability to meet debt obligations) increases. Financial distress costs include direct costs (legal fees, administrative costs of bankruptcy) and indirect costs (loss of customers, suppliers, employees, investment opportunities). Firms with high operating leverage, high asset specificity, or volatile earnings face higher financial distress costs and should use less debt (Myers, 1977; Okafor and Udeh, 2021).

Agency Costs: Conflicts between shareholders (principals) and managers (agents) create agency costs. Debt can reduce agency costs by limiting free cash flow available for managerial perks (free cash flow hypothesis). However, debt can also create agency costs of debt (underinvestment, asset substitution). Firms with high growth opportunities should use less debt to avoid underinvestment (Jensen and Meckling, 1976; Myers, 1977).

Asymmetric Information: Managers have more information about the firm’s prospects than outside investors (information asymmetry). The pecking order theory suggests that firms prefer internal financing (retained earnings) to avoid adverse selection. When internal funds are insufficient, firms prefer debt (less information-sensitive) over equity (more information-sensitive). Highly profitable firms generate more internal funds and therefore use less debt (Myers and Majluf, 1984).

Signaling: Firms use capital structure decisions to signal private information to the market. Issuing debt signals management’s confidence in future profitability (because debt requires fixed payments). Issuing equity signals that management believes shares are overvalued. Thus, profitable firms may use more debt to signal quality (Ross, 1977).

Asset Structure: Firms with tangible assets that can serve as collateral can borrow more (lower agency costs of debt). Firms with intangible assets (goodwill, patents, brand value) have less collateral and borrow less. Healthcare firms have significant tangible assets (land, buildings, medical equipment) that can serve as collateral, potentially enabling higher leverage (Myers and Majluf, 1984).

Profitability: Highly profitable firms generate more retained earnings, reducing the need for external financing. According to the pecking order theory, profitable firms have lower leverage (negative relationship). According to the trade-off theory, profitable firms may have higher leverage (to take advantage of tax shields). The empirical relationship is a key focus of this study (Fama and French, 2002; Frank and Goyal, 2009).

Firm Size: Larger firms are more diversified, have lower bankruptcy risk, and have better access to capital markets. Therefore, larger firms can use more debt. Size is often used as a control variable in leverage studies (Rajan and Zingales, 1995).

Growth Opportunities: Firms with high growth opportunities (high market-to-book ratio) have more flexibility and need to avoid underinvestment. They should use less debt to preserve financial flexibility. Healthcare firms with expansion plans (new hospitals, new services) may have high growth opportunities (Myers, 1977).

2.5 Types and Measurement of Leverage

Leverage can be measured in several ways, each capturing different aspects of the firm’s use of borrowed funds:

Debt Ratio (DR) : Total Liabilities ÷ Total Assets. This measures the proportion of a firm’s assets financed by debt (including short-term and long-term debt). A higher debt ratio indicates greater leverage. For Nigerian healthcare firms, debt ratios vary by subsector.

Debt-to-Equity Ratio (DER) : Total Liabilities ÷ Shareholders’ Equity. This measures the relative claims of creditors versus owners. A higher debt-to-equity ratio indicates greater leverage and higher financial risk.

Long-Term Debt Ratio (LTDR) : Long-Term Debt ÷ Total Assets. This measures the proportion of assets financed by long-term debt, excluding short-term obligations. Long-term debt is often associated with capital investments (buildings, equipment).

Short-Term Debt Ratio (STDR) : Short-Term Debt ÷ Total Assets. This measures the proportion of assets financed by short-term debt (bank overdrafts, trade credit, short-term loans). Healthcare firms may use short-term debt for working capital (inventory, accounts receivable).

Interest Coverage Ratio (ICR) : Earnings Before Interest and Taxes (EBIT) ÷ Interest Expense. This measures the firm’s ability to pay interest from operating profit. A higher ratio indicates greater ability to service debt. ICR below 1 indicates that operating profit is insufficient to cover interest.

Times Interest Earned (TIE) : Same as ICR, a measure of debt servicing capacity.

Debt-to-Capital Ratio (DCR) : Total Debt ÷ (Total Debt + Shareholders’ Equity). This measures the proportion of the firm’s capital (debt + equity) that comes from debt (Brigham and Ehrhardt, 2017; Ross et al., 2019).

For healthcare firms, the most commonly used leverage measures are the debt ratio and debt-to-equity ratio, as they capture overall leverage. Interest coverage ratio is important for assessing risk of financial distress.

2.6 Concept of Profitability

Profitability is the ability of a firm to generate earnings from its operations and investments. It is a primary measure of firm performance and a key determinant of firm value, access to financing, and long-term survival. Profitability reflects how efficiently a firm uses its resources (assets, equity, capital) to generate profits. Profitable firms are more attractive to investors, creditors, and other stakeholders (Penman, 2018; Brigham and Ehrhardt, 2017).

For healthcare firms, profitability is influenced by: (a) patient volume and service mix, (b) pricing power (ability to set fees), (c) reimbursement rates from insurers and government programs, (d) cost of drugs and medical supplies, (e) labor costs (physician salaries, nurse wages), (f) occupancy rates and capacity utilization, (g) technology investment (efficiency gains), (h) regulatory environment (licensing fees, compliance costs), (i) competition (market structure), and (j) macroeconomic conditions (inflation, exchange rates) (World Bank, 2018; Okafor and Udeh, 2020).

Profitability is distinct from liquidity (ability to meet short-term obligations) and solvency (ability to meet long-term obligations). A firm can be profitable but illiquid (e.g., profits tied up in accounts receivable). A firm can be liquid but unprofitable (e.g., selling products at a loss). Profitability is a necessary condition for long-term survival, but not sufficient (liquidity and solvency are also required).

2.7 Measurement of Profitability

Profitability can be measured in several ways, each capturing different aspects of firm performance:

Return on Assets (ROA) : Net Profit ÷ Total Assets. This measures how efficiently a firm uses its assets to generate profit. ROA is a comprehensive measure of operating performance, unaffected by leverage (since assets include both debt and equity financing). ROA = Net Profit Margin × Asset Turnover. For healthcare firms, ROA reflects both pricing, cost control, and asset utilization.

Return on Equity (ROE) : Net Profit ÷ Shareholders’ Equity. This measures the return earned on owners’ investment. ROE is affected by leverage; firms with high leverage can have high ROE even if ROA is moderate (due to the equity multiplier). ROE = ROA × Equity Multiplier (Total Assets/Equity). For healthcare firms, ROE is important for shareholders.

Return on Capital Employed (ROCE) : Earnings Before Interest and Taxes (EBIT) ÷ (Total Assets – Current Liabilities). This measures the return on long-term capital (debt + equity). ROCE excludes short-term liabilities and is not affected by tax rates.

Gross Profit Margin (GPM) : (Revenue – Cost of Goods Sold) ÷ Revenue. This measures the percentage of revenue remaining after deducting direct costs (drugs, supplies, labor). For healthcare firms, GPM reflects pricing and procurement efficiency.

Operating Profit Margin (OPM) : Operating Profit (EBIT) ÷ Revenue. This measures profitability after deducting both direct costs and operating expenses (salaries, rent, depreciation, utilities). OPM reflects core operational efficiency.

Net Profit Margin (NPM) : Net Profit ÷ Revenue. This measures overall profitability after all expenses (including interest and taxes). NPM is affected by financing decisions (interest) and tax rates.

Earnings Per Share (EPS) : Net Profit ÷ Number of Outstanding Shares. This measures profit attributable to each share, important for shareholders (Penman, 2018; Brigham and Ehrhardt, 2017).

For healthcare firms, ROA and ROE are the most commonly used profitability measures in capital structure studies, as they capture the overall impact of financing decisions on performance.

2.8 Leverage and Profitability

The relationship between leverage and profitability has been extensively studied in corporate finance, with conflicting theoretical predictions and empirical results.

Theoretical Predictions:

The trade-off theory predicts a positive relationship between leverage and profitability. Profitable firms have higher taxable income, making the tax shield of debt more valuable. Profitable firms also have lower bankruptcy risk, allowing them to use more debt. Therefore, profitable firms should have higher leverage (Modigliani and Miller, 1963; Myers, 1984).

The pecking order theory predicts a negative relationship between leverage and profitability. Profitable firms generate more retained earnings, reducing the need for external financing. When external financing is needed, firms prefer debt over equity. However, highly profitable firms with ample retained earnings will have low leverage. Therefore, leverage and profitability are negatively correlated (Myers and Majluf, 1984).

The agency theory has two competing predictions. The free cash flow hypothesis suggests that debt can reduce agency costs by limiting free cash flow (Jensen, 1986). Firms with high profitability (and high free cash flow) may use debt to discipline managers, suggesting a positive relationship. The underinvestment hypothesis suggests that firms with high growth opportunities (often profitable) should use less debt to avoid underinvestment, suggesting a negative relationship (Myers, 1977).

The signaling theory suggests that firms with high profitability may use more debt to signal confidence in future prospects (since debt requires fixed payments). This suggests a positive relationship (Ross, 1977).

Empirical Evidence:

Empirical studies have produced mixed results. In developed markets, many studies have found a negative relationship between leverage and profitability, consistent with the pecking order theory (Fama and French, 2002; Frank and Goyal, 2009). In emerging markets, evidence is mixed; some studies find a negative relationship, others find a positive relationship, and still others find no significant relationship.

In Nigeria, studies on the leverage-profitability relationship have produced mixed results. Some studies have found a negative relationship (higher leverage reduces profitability), consistent with the pecking order theory. Others have found a positive relationship (higher leverage increases profitability), consistent with the trade-off theory. The relationship may vary by industry, firm size, and time period. For the healthcare industry specifically, limited research is available. A study by Adebayo and Oyedokun (2019) found a negative relationship between leverage and profitability for Nigerian healthcare firms (debt ratio negatively related to ROA). A study by Okafor and Udeh (2020) found that the relationship varied across healthcare subsectors (hospitals had a stronger negative relationship than pharmaceutical manufacturers). These mixed results warrant further investigation.

Moderating Factors:

The leverage-profitability relationship may be moderated by several factors: (a) firm size – larger firms may be able to use more debt without increasing distress risk, (b) growth opportunities – high-growth firms may have a negative relationship (underinvestment risk), (c) asset tangibility – firms with more tangible assets (collateral) may have a positive relationship, (d) industry – the relationship may differ across industries, (e) macroeconomic conditions – during recessions, the negative impact of leverage may be stronger, and (f) institutional environment – in countries with weaker creditor rights, the relationship may differ (Rajan and Zingales, 1995; Frank and Goyal, 2009).

2.9 Theoretical Framework

The theoretical framework for this study is anchored on several theories that explain the relationship between leverage and profitability. These theories provide the conceptual foundation for understanding why leverage affects profitability and what factors moderate this relationship.

2.9.1 Trade-Off Theory

The trade-off theory (Modigliani and Miller, 1963; Myers, 1984) suggests that firms balance the benefits of debt (tax shield, discipline) against the costs of debt (financial distress, agency costs). The optimal capital structure is achieved when the marginal benefit of debt equals the marginal cost. According to this theory, profitable firms have higher taxable income, making the tax shield more valuable. Profitable firms also have lower bankruptcy risk (more stable earnings), allowing them to use more debt. Therefore, the trade-off theory predicts a positive relationship between leverage and profitability.

In the context of Nigerian healthcare firms, profitable hospitals and pharmaceutical manufacturers may benefit from the tax deductibility of interest on loans used to finance medical equipment and facility expansion. However, healthcare firms face regulatory risks and reimbursement uncertainty that increase financial distress costs, potentially limiting the use of debt.

2.9.2 Pecking Order Theory

The pecking order theory (Myers and Majluf, 1984) suggests that firms prefer internal financing (retained earnings) over external financing due to information asymmetry. When internal funds are insufficient, firms prefer debt (less information-sensitive) over equity (more information-sensitive). According to this theory, profitable firms generate more retained earnings, reducing the need for external financing. Therefore, the pecking order theory predicts a negative relationship between leverage and profitability.

For Nigerian healthcare firms, the pecking order theory may be particularly relevant due to information asymmetry between healthcare firm managers (who have detailed knowledge of patient volumes, reimbursement rates, and regulatory risks) and outside investors. Profitable healthcare firms may rely on retained earnings to fund expansion, resulting in lower leverage.

2.9.3 Agency Theory

Agency theory (Jensen and Meckling, 1976; Jensen, 1986) explains conflicts of interest between shareholders (principals) and managers (agents). Debt can reduce agency costs by limiting free cash flow (free cash flow hypothesis). When firms have high profitability, they generate free cash flow that managers may waste on perquisites or unprofitable investments. Debt obligates the firm to make fixed interest payments, reducing free cash flow and disciplining managers. Therefore, agency theory predicts that profitable firms may use debt to reduce agency costs, suggesting a positive relationship.

However, agency theory also predicts that debt can create agency costs of debt (underinvestment, asset substitution). Firms with high growth opportunities (often profitable) may avoid debt to preserve financial flexibility, suggesting a negative relationship. The net effect depends on the firm’s characteristics.

For Nigerian healthcare firms, agency theory suggests that debt may discipline managers of profitable firms, but the high capital intensity and regulatory environment may increase the costs of financial distress.

2.9.4 Signaling Theory

Signaling theory (Ross, 1977) suggests that firms use financial decisions to signal private information to the market. Issuing debt signals management’s confidence in future profitability (since debt requires fixed payments). Therefore, firms with high profitability may use more debt to signal quality, suggesting a positive relationship between leverage and profitability.

For Nigerian healthcare firms, the signaling role of debt may be important given information asymmetry between healthcare firm managers and investors. However, the high interest rate environment in Nigeria (15-25%) may make debt signaling costly.

2.9.5 Integration of Theories and Justification for This Study

The theoretical framework for this study integrates these four theories. The trade-off theory and signaling theory predict a positive relationship between leverage and profitability. The pecking order theory predicts a negative relationship. Agency theory predicts a relationship that may be positive or negative depending on firm characteristics (growth opportunities, free cash flow). Given these conflicting predictions, the relationship between leverage and profitability is an empirical question that requires investigation in the context of listed healthcare firms in Nigeria.

This study will test the following hypotheses based on the theoretical framework:

• If the trade-off theory dominates, leverage will have a positive effect on profitability (H₁: leverage positively affects profitability).
• If the pecking order theory dominates, leverage will have a negative effect on profitability (H₁: leverage negatively affects profitability).
• If agency theory dominates, the relationship may be positive or negative depending on firm characteristics.

The study will also control for firm size, asset tangibility, growth opportunities, and other factors that may moderate the leverage-profitability relationship.

2.10 Summary

This chapter has reviewed the literature on leverage and profitability of listed healthcare firms in Nigeria. The concept of capital structure refers to the mix of debt and equity financing. Leverage is a key component of capital structure, referring to the use of borrowed funds. Theoretical factors influencing leverage include tax shield, financial distress costs, agency costs, asymmetric information, signaling, asset structure, profitability, firm size, and growth opportunities. Types of leverage include operating leverage (fixed operating costs) and financial leverage (fixed financial costs). Leverage is measured using debt ratio, debt-to-equity ratio, interest coverage ratio, and other metrics.

Profitability is the ability to generate earnings and is measured using return on assets (ROA), return on equity (ROE), net profit margin, and other metrics. The relationship between leverage and profitability has conflicting theoretical predictions: trade-off theory predicts a positive relationship; pecking order theory predicts a negative relationship; agency theory predicts a relationship that may be positive or negative; signaling theory predicts a positive relationship. Empirical evidence is mixed, with some studies finding a negative relationship and others a positive relationship.

The theoretical framework integrates the trade-off theory, pecking order theory, agency theory, and signaling theory to explain the leverage-profitability relationship for listed healthcare firms in Nigeria. The chapter provides the foundation for the empirical analysis in subsequent chapters.