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The Influence of Capital Structure on the Financial Performance of Small and Medium Enterprises in Mitooma District, Uganda

Karuhanga Obed, David Nyambane and Andrew Nyakundi

Faculty of Business Administration, Kampala International University Western Campus Uganda.

ABSTRACT

Small and medium enterprises (SMEs) are pivotal for a nation’s economic growth, representing 90% of global businesses and generating 50% of job opportunities. In Uganda, this sector employs approximately 2.5 million individuals and contributes 18% to the GDP. Despite this significant impact, 45% of Ugandan SMEs face imminent collapse due to financial hurdles. Consequently, this study aimed to explore how capital structure influences the financial performance of SMEs in Mitooma District. The objectives were to scrutinize the impact of equity capital, debt capital, and retained earnings on SMEs’ financial performance. Grounded in the Pecking Order Theory and Trade Theory, the study followed a quantitative research approach employing a descriptive research design. With a population of 836, a scientifically determined sample of 271 was selected through random and purposive sampling methods. Data collection involved a validated and reliable questionnaire. Using regression analysis through SPSS, the study found that the model provided a robust level of prediction (R=.678), explaining 45.9% (R2=.459) of the variability in SMEs’ financial performance. Specifically, equity capital (t=-1.975, P=.045, P<.05), debt capital (t=7.015, P=.000, P<.05), and retained earnings (t=6.289, P=.000, P<.05) emerged as statistically significant factors. Conclusively, the study highlighted that equity capital, debt capital, and retained earnings significantly influence SMEs’ financial performance. To enhance their financial standing, the recommendation is for SMEs to adopt innovative strategies. These findings hold relevance for policymakers, SME stakeholders, academic circles, and SME owners, offering valuable insights into bolstering this critical sector.

Keywords: Small and medium Enterprises, Economic development, financial performance, Equity capital, Retained earnings.

INTRODUCTION

Globally, Small and Medium Enterprises (SMEs) play a major role in most economies, particularly in developing countries. SMEs account for the majority of businesses worldwide and are important contributors to job creation and global economic development. They represent about 90% of businesses and more than 50% of employment worldwide. Formal SMEs contribute up to 40% of national income (GDP) in emerging economies [1]. Small and Medium Enterprises first became prevalent in the United States in 1782, with the majority of non-manufacturing enterprises having annual revenue of less than $7 million US and fewer than 500 employees for manufacturing businesses. Other criteria used to categorize small businesses besides employee count incorporated yearly sales (turnover), asset value, and net profit [2, 3]. The SMEs in India were divided into two groups in the 1920s: those utilizing power and having less than 50 employees, and those not using power and having between 51 and 99 employees. In China, SMEs contribute significantly to China’s social economy due to their large numbers (over 90% of all enterprises). SMEs collectively contribute 80% of China’s employment, 70% of technological innovation, 60% of GDP, and 50% of tax revenue [4]. However, their performance remains unstable because several SMEs that go bankrupt and close down in the community are far greater than the overall decline, considering that new businesses are set up in the original locations soon after the previous enterprises cease operations and close down [4, 5]. Micro and small businesses provided around 45% of India’s overall export revenue [6]. Small businesses indeed play a significant role in generating money and jobs in many nations around the world. However, the main factor used to distinguish small-scale enterprises from medium- and large-sized industries has been the capital resources spent on establishing plants and machinery. If an industrial unit meets the capital investment threshold set by the Government of India for the small-scale sector, it can be designated as a small-scale unit. According to [7], there is no fluctuation in the growth scenario of the MSMEs, which indicates that MSMEs are the ever-green sector in India and positively contribute to the economic growth of the nation [7]. Small and Medium Enterprises in Africa are traced to have emerged way back in the 1950s during the colonial times and have been seen as the origin of modern business in Africa since the independence of most African countries [8]. The crucial paper No. 24 of 1945, which forms the historical foundation of Nigeria’s small and medium-sized businesses, was published in 1946. A ten-year development and welfare plan for Nigeria was presented. It has been said that small and medium-sized businesses are always necessary in any economy. In Nigeria’s economic environment, small-scale businesses are still present and form the foundation for the country’s current degree of industrialization, modernization, urbanization, and gainful and meaningful employment [13]. According to Global Entrepreneurship Monitor (GEM), out of the businesses that start each year in Africa, 80% to 90% are SMEs but over 40% of them collapse before five years due to profitability, liquidity and funding challenges [10]. They faced a variety of difficulties, such as a lack of cash or insufficient capital to purchase the inventory and equipment necessary for the majority of these sectors. Loans from financial and non-financial entities took time to get and were typically only granted on paper. The SMEs managed to thrive despite the capital scarcity factor [11]. In Ghana, the definitions used are based on capital requirements and on employment size. Enterprises qualify as micro, small or medium-scale enterprises if they fulfil the maximum ceilings for staff headcount and capital investment. Thus, micro-businesses employ one to five employees with a turnover of $10,000, small employ 6 to 29 with a turnover of $ 100.000 and medium employ 30 to 100 with a turnover of $1,000,000.

SMEs in Uganda are a driving force for the promotion of the country’s economic development [12]. SMEs have significant socio-economic characteristics such as their contribution to new job creation and reduction of poverty contributing positively to the GDP of the country [13]. The government of Uganda through National Small Business Survey have prioritized access to finance, improving infrastructure, providing business services and improving security for the smooth running of SMEs in the country [14]. Despite the above strategies, SMEs in Mitooma District are faced with financial performance challenges whereby; 45% of them are limping and others are on the verge of collapsing [15]. However, their financial performances are poor as reflected in terms of profitability, turnover, liquidity ratio (Annual report 2020/2021). Thus, the issue of concern was equity capital, debt capital and retained earnings whose effects on financial performance are unknown. If the above problem continues there is a likelihood of closure or collapse of SMEs in Mitooma District which will affect the country’s economy. Therefore, the study sought to examine the effect of capital structure on financial performance of SMEs in Mitooma District.

CONCLUSION

Overall, these results indicate that equity capital has a significant and positive effect on the financial performance of SMEs in Mitooma district. SMEs with higher levels of equity capital tend to exhibit better financial performance. This highlights the importance of equity financing in supporting the growth and sustainability of SMEs in the district. However, it is essential to consider other factors not included in the model that may also impact the financial performance of SMEs, such as market conditions, managerial skills, and access to resources and opportunities. Based on these findings, we can conclude that there was a positive and significant relationship between debt capital and the financial performance of SMEs in Mitooma district. This implies that SMEs that utilize higher levels of debt capital are more likely to achieve better financial performance. However, it is important to note that correlation does not imply causation, and other factors may also contribute to the financial performance of SMEs. The correlation analysis results indicate a significant positive correlation between debt capital and the financial performance of SMEs in Mitooma district. Based on these findings, we can infer that there is a positive and significant relationship between retained earnings and the financial performance of SMEs in Mitooma district. This implies that SMEs that have higher levels of retained earnings are more likely to exhibit better financial performance.

Recommendations

From the findings, SMEs in Mitooma district should consider prioritizing the accumulation of equity capital as a means to enhance their financial performance. This can be achieved through various strategies such as retaining earnings, attracting external equity investors, or seeking partnerships with other businesses. By increasing their equity capital, SMEs can strengthen their financial position, improve their creditworthiness, and have better access to additional funding sources in the future. SMEs with higher levels of debt capital tend to exhibit better financial performance. These findings emphasize the role of debt financing in supporting the financial growth and success of SMEs in the district. However, it is important to consider other factors that may influence financial performance, such as market conditions, operational efficiency, and strategic management practices. Retained earnings, which represent the accumulated profits that have been reinvested into the business, can serve as a valuable source of internal financing for SMEs. By reinvesting them back into the business, SMEs can strengthen their financial position, enhance their operational capabilities, and support growth initiatives. It highlights the importance of effective financial management practices that focus on building and utilizing retained earnings to improve the financial performance and long-term sustainability of SMEs in Mitooma district.

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CITE AS: Karuhanga Obed, David Nyambane and Andrew Nyakundi (2023). The Influence of Capital Structure on the Financial Performance of Small and Medium Enterprises in Mitooma District, Uganda. IDOSR JOURNAL OF CURRENT ISSUES IN ARTS AND HUMANITIES 9(2):1-22. https://doi.org/10.59298/IDOSRJCIAH/2023/1.3.3300

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