CHAPTER ONE

INTRODUCTION

1.1 Background of the study

Small and medium enterprises (SMEs) are the backbone of many market economies as well as an alternative motor for economic development (Tuymuratovich, 2021). Geographical boundaries do not limit their importance. For example, SMEs account for 96 per cent of all businesses in Asia (Pinho et al., 2018). SMEs have a crucial role in achieving the economic goals, in which they contribute to the diversification of the economy, reduce unemployment, enhance the country’s production, and boost exportation. SMEs have contributed to the creation of nine jobs from every ten jobs in the world (Bruhn et al., 2017).  However, SMEs around the world are suffering from many constraints that prevent their expansion and growth. The literature has revealed that lack of finance is a crucial obstacle that faces SMEs in any region in the world (Seker & Correa, 2017), because they need financial resources that fit their characteristics to fill the financing gap (Beck, 2007). Ayadi and Gadi (2013) mentioned weak capital structure as the main characteristic of SMEs.

For the success of any new or old business, funds are a prerequisite as they act as a lifeline of any business operation. This funding is required for expanding the business cope as well as to carry out daily operations smoothly. The funds are termed as Capital representing the foundation of any business. This capital comes to the firm as an investment from other people expecting and demanding reasonable returns against the usage of their investment (Javed et al, 2018). However, one of the most difficult subject to understand in corporate finance literature is the capital structure (Barine 2012). Capital structure is the composite of borrowed fund and owners’ fund that adds up to total capital employed of the business organization. The ratio of external source (borrowed) to internal source is a cautious decision for corporate managers. Capital structure decisions are of importance when considering the factors that affects performance of a firm. This therefore calls for a lot of care and attention when making decisions on capital structure. Referring to the balance sheet of a firm, a comprehensive status of the firm as regards all types of assets and liabilities are reflected (Velnampy and Niresh, 2012). The term capital structure of an enterprise is actually a mixture of ordinary share, preferred shares and long-term debts. A number of considerations requires to put in place as far as the optimum capital structure is concerned. With the combination of various sources of capital, firms may find it difficult to realize the goal of utilizing their funds economically. Therefore, it is progressively relied that a firm need organize its capital structure for an optimum use of funds and to be in a position that enhance dealing with upcoming situation (Pandy, 2009).

According to Pandy (2009) financial performance measures of an institution includes profitability and liquidity among other that provides useful parameters for measuring the previous performance of the firm as well as the present status of the business. How well a business utilizes its assets in its operations to generate profit signifies its performance that is measured subjectively. Brigham and Gapenski (1996) supported the theory of Modigliani and Miller model. On the other hand, the presence of bankruptcy costs goes hand in hand with the firm’s debt. According to the conclusion an explicit association amid capital structure and financial performance of institution was suggested (Brigham and Gapenski 1996). The inspiration for aiming the SMEs comes from the fact that, they are force behind thriving in a number economy in today’s world.

The effects of capital structure on the profitability of small enterprises are critical for understanding their financial performance and sustainability. Capital structure, defined as the mix of debt and equity financing, plays a significant role in determining profitability outcomes for small and medium-sized enterprises (SMEs). Ishaq et al., (2022) stated that an optimal capital structure can enhance profitability by minimizing the cost of capital and maximizing returns on investment. For instance, a higher debt-to-equity ratio may lead to increased financial leverage, which can amplify profits when the business performs well; however, it also introduces higher risk, particularly in volatile markets. Conversely, Radjal and Barrak (2017) Indicated that reliance on equity financing can provide a more stable financial base but may limit growth potential due to the higher cost of equity compared to debt.

The essence of capital structure theory lies in finding the right balance that maximizes a firm’s value while minimizing its cost of capital.  In the African, the landscape for SMEs is often fraught with challenges, including limited access to finance, high-interest rates, and economic instability. According to the African Development Bank (2013), SMEs contribute over 80% of the total employment and 40% of GDP in many African countries, highlighting their crucial role in economic development. However, despite their potential, SMEs in Africa face significant barriers in obtaining financing, leading to suboptimal capital structures that can adversely affect profitability (Beck & Demirgüç-Kunt, 2006).

Focusing specifically on Cameroon, SMEs form the backbone of the economy, accounting for approximately 90% of businesses and employing over 70% of the workforce (NIS, 2020). However, these enterprises often struggle with financial constraints that limit their growth and profitability. Research by Tchamyou (2019) indicates that access to finance is a critical determinant of SME performance in Cameroon. The majority of these businesses rely on informal financing sources, which may not provide the ideal capital structure necessary for sustainable growth. Moreover, the economic environment in Cameroon is characterized by volatility and uncertainty, which can exacerbate the challenges faced by SMEs in managing their capital structures. Economic shocks, fluctuating commodity prices, and regulatory hurdles pose significant risks, making it essential to examine how these factors influence the relationship between capital structure and profitability.

In Bamenda, capital structure of small and medium size enterprises significantly influences their profitability, as evidenced by various studies. Findings et al., (2023) indicates that the reliance on different sources of capital, such as debt, equity, and retained earnings, can lead to varying impacts on financial performance. For instance, a study on microfinance institutions (MFIs) in Bamenda found a statistically significant negative relationship between debt and financial sustainability, while retained earnings showed a positive correlation with sustainability. This suggests that small enterprises that prioritize equity and retained earnings over debt may achieve better profitability outcomes (Kum, 2017). Additionally, the findings highlight the importance of a balanced capital structure that minimizes reliance on grants and external funding, which can hinder longterm financial sustainability (Abor, 2005).

1.2 Statement of the problem

The relationship between capital structure and profitability has been a focal point of financial research globally, particularly as Small and Medium Enterprises (SMEs) increasingly contribute to economic development. In the global context, studies indicate that an optimal capital structure can enhance profitability by balancing debt and equity financing. For instance, according to Myers (2001), leveraging debt can provide tax benefits and lower the cost of capital, which can potentially increase firm profitability. However, excessive reliance on debt may also lead to financial distress, particularly in volatile markets.

In the African context, the landscape of SME financing is characterized by limited access to capital and high-interest rates, which can hinder growth and profitability. A study by Abor and Biekpe (2007) suggests that SMEs in Ghana face unique challenges in capital structure decisions, affecting their overall performance. This trend is mirrored across various African nations, where SMEs often struggle to optimize their capital structures within the constraints of their operating environments.

Specifically, in Cameroon, SMEs represent a significant portion of the economy, yet they encounter considerable obstacles related to capital acquisition, which in turn affects their profitability. Research by Ndofor and Tengeh (2017) reveals that Cameroonian SMEs often rely heavily on informal financing due to limited access to formal banking channels. This reliance on informal sources can lead to suboptimal capital structures, ultimately impacting profitability. Furthermore, the economic instability in the region exacerbates the difficulties faced by these enterprises, making it critical to understand the intricacies of capital structure decisions in relation to profitability.

Establishing optimum capital structure in financial management is an important assignment. Decisions on capital structure and profitability are made while taking into account factors that includes financial performance, liquidity and control. In Bamenda, the capital structure of small and medium enterprises (SMEs) plays a crucial role in determining their profitability, as it influences financial stability, operational efficiency, and growth potential. SMEs often rely on a mix of equity, debt, and retained earnings to finance their operations, and the balance between these sources can significantly impact their cost of capital and risk profile. A well-structured capital configuration allows for easier access to funding, reduces financial constraints, and enhances investment in productive assets, thereby fostering profitability. However, it has been observed that imbalanced capital structure led to increased financial costs and vulnerability, ultimately limiting the growth and sustainability of these enterprises. It is against this backdrop that the study sets out to examine, the effects of capital structure on Profitability in small and medium size enterprises in Bamenda Town.

Thus, this research seeks to explore the effect of capital structure on the profitability of SMEs in Bamenda Cameroon, addressing the gap in literature regarding the unique challenges faced by these enterprises in balancing debt and equity financing in a developing economy.

1.3 Research Questions

1.3.1 Main Research question

What are the effects of capital structure on the profitability of small and medium-sized enterprises (SMEs) in Bamenda?

1.3.2 Specific Research Questions

• What is the impact of the debt-to-equity ratio on the profitability of SMEs in Bamenda?
• How does the cost of debt influence the profitability of SMEs in Bamenda?
• What role does equity financing play in determining the profitability of SMEs in Bamenda?

1.4 Research Objectives

1.4.1 Main Research Objective

To analyze the relationship between capital structure and profitability in small and medium-sized enterprises.

1.4.2 Specific Research Objectives

• To evaluate the effect of the debt-to-equity ratio on the profitability of SMEs in Bamenda
• To assess the impact of the cost of debt on the profitability of SMEs.in Bamenda

To investigate the influence of equity financing on the profitability of SMEs in Bamenda