The Importance of Short Term Financing Sources in Small Firms

Abstract

Traditional theory based understandings of the use of external financing sources by business entities are most commonly informed by variations of agency theoretic approaches including the pecking order framework. This traditional understanding is that as firms become larger and more successful they are better able to overcome information asymmetry problems and also are likely to benefit from the tax advantages of debt over equity. Consequently they rely more on external debt. This paper reports results (from the analysis of a large Australian database) that explore differences in the equity and debt structure of small firms. Initially the paper provides descriptive detail of financial structure groupings that identify four principal groups with significantly different core financing (the bank loan debt group; the related persons debt group; the short term debt group and the working owner equity group). Results are presented of analysis that seeks to identify associations with a range of variables likely to be associated with a firm’s membership of one of the financial structure groups. Included are size measures, age, asset tangibility, industry, profitability, liquidity, growth, risk, business practices, and, owners' characteristics. Expectations from theory are that, for most of these variables, higher (better performed) values would be associated with the bank loan debt group. The results, however, indicate that the larger, better performing firms are in the short term debt group. This implies that small firms may not take advantage of the information asymmetry advantages they gain through size and performance to increase external medium to long term borrowing. Rather they seem more likely to use the benefits of their size and performance to develop stronger short term relationships with product and service suppliers (through trade credit) and finance providers (through short term and overdraft bank borrowings). These results are most closely associated with the pecking order framework approach to understanding small firm financial structures, although the strength of the reliance on short term sources is greater than that expected from traditional considerations of that framework.