The determinants of the costs of financial distress in SMEs

Abstract

We propose a theoretical model that argues that the expected financial distress costs in small- and medium-sized enterprises (SMEs) result from the interaction of the financial distress likelihood and the magnitude of the consequences borne whenever financial failure occurs. The empirical evidence from five European countries, where the insolvency laws are representative of prevailing institutional traditions, supports this model. We reveal that the ex ante financial distress costs suffered by a firm depend not only on the likelihood of financial distress but also on the variables that influence the amount of time and costs incurred during the insolvency process. Specifically, financial costs are lower where the capacity to use tangible assets as collateral and short-term debt is greater; they are higher the greater the use of long-term secured debt. Additionally, the effect of these variables is moderated by a firm’s ownership and by the nature of the insolvency law in operation. The timely management of these variables can avoid the high costs involved in an involuntary exit.

Public vs Private SMEs: A Comparison of Distress Hazard

“…One-year financial distress hazard analysis of listed and unlisted SMEs is performed using discrete-time duration-dependent hazard rate modelling technique and set of financial covariates with established significance of financial distress prediction in earlier studies. The definition of financial distress employed based on firms' financial performance is adapted from Keasey et al (2014). We report significant differences between distress hazard of listed and unlisted SMEs.…”

“…Financial ratios with established reputation of distress prediction in earlier studies are being used as covariates along with liquidity measure of Amihud (2002) and illiquidity measure of Florackis et al (2011). Our definition of financial distress based on firms' financial performance is adapted from Keasey et al (2014). To gauge within-sample classification and out-of-sample validation performance of multivariate models developed, we estimate area under the Receiver Operating Characteristic (ROC) curves of respective hazard models 1 .…”

“…Further, filing for legal bankruptcy is the least efficient exit strategy for SMEs (Balcaen et al 2012) and distress definitions based on bankruptcy laws are inefficient in comparison to distress definition based firms' financial performance (see Gupta et al 2015). Thus, following Keasey et al (2014), an SME experiencing financial distress is defined as one that satisfies the following: (i) its expenses exceeds earnings during two consecutive years, (ii) its total debt exceeds net worth during those two years in (i), and (iii) it records negative growth in net worth during the same consecutive periods in (i) and (ii). Additionally, a firm is also recorded as financially distressed in the year immediately following these distress events.…”

“…Given the increased importance of SMEs, a significant volume of academic literature on SMEs financial distress has emerged in recent years (e.g. Altman and Sabato 2007, Gupta, Wilson, et al 2014a, 2014b, Keasey et al 2014.…”

Evaluation of Enterprise Survival: Case of Latvian Enterprises

“…Moreover, corporate financial distress could lead to domino effect affecting both stake-/ shareholders. The timely management of symptoms can help to avoid high costs (Keasey, Pindado, & Rodrigues, 2015). To prevent unfavourable internal and external costs, there is a necessity of implementing tools that could provide an accurate and timely manner reliable answers.…”