Capital Structure and Financing of Small and Medium Sized Enterprises: Empirical Evidence from a Sri Lankan Survey

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1 Journal of Small Busness and Entrepreneurshp Development June 2015, Vol. 3, No. 1, pp ISSN: (Prnt), (Onlne) Copyrght The Author(s). All Rghts Reserved. Publshed by Amercan Research Insttute for Polcy Development DOI: /jsbed.v3n1a6 URL: Captal Structure and Fnancng of Small and Medum Szed Enterprses: Emprcal Evdence from a Sr Lankan Survey Menke, L.M.C.S. 1 Abstract Ths paper presents an emprcal examnaton of captal structure choces and fnancng of small and medumszed enterprses (SMEs) n Sr Lanka. A survey was carred out based on 300 SMEs and the hypotheses formulated from peckng order and lfe cycle theores are tested on a number of unvarate and multvarate logstc regresson models. The results suggest that age, sze, ownershp structure, nformaton asymmetry and level of ntangble actvty are mportant determnants of the captal structure of SMEs. It s evdent that when frms become older and larger they accumulate enough fxed assets by elmnatng nformal asymmetry, they tend to acqure long term loans provdng fxed assets as collaterals. The results also reveal that the ndustryspecfc effects are mportant n the context of SME captal structures and SMEs n Metal and Wood ndustres are less lkely to use nternal fnance whle the SMEs n Textle ndustry are more lkely to use longterm debts. The results support the Peckng Order Theory and the Lfe Cycle Theory. Keywords: Captal Structure, Lfe Cycle Theory, Logstc Regresson, Peckng Order Theory, Small and Medum Szed Enterprses, Sr Lanka 1. Introducton Small and medum-szed enterprses (SMEs) are vtal for the growth and development of the Sr Lankan economy because they encourage entrepreneurshp, generate employment, reduce poverty and promote of backward lnkages (Kayanulad and Quartey, 2000; Tagoe et al., 2005). SMEs n Sr Lanka play a vtal role n the economy accountng for 82% of all frms, 20% - 40% of employment and about 20% of value added to the GDP (Abeyratne, 2005). Further, the SMEs supply goods and servces to many companes that comprse the membershp of the Board of Investment (BOI). Moreover accordng to Department of Census and Statstcs (2003) about 90% of SMEs are scattered n rural areas of the country. Therefore, such SMEs have a hgh potental for rural sector development. As such the promotng the growth and compettveness n SMEs wll lead not only to growng socal and economc returns nternally but also to allow the prvate sector partcpaton n the global economy. However, ths growth process has been constraned by the lmted avalablty and accessblty of fnancal resources to meet a varety of operatonal and nvestment needs wthn the SME sector. Both demand and supply sde factors have constraned ther share to ths fnancng problem n the country. There s an extensve lterature of the frm captal structure and the debt equty mx s one of the major topcs n the lterature on corporate fnance. Demand sde of SME fnancng are based on the well-establshed fact that the owners are extremely reluctant to gve up control of ther busness and they try to meet ther fnancng needs from a peckng order for whch ths study tres to examne the less studed demand sde of captal structures of SMEs n the Sr Lankan context. The most wdely accepted vew of the small busness captal structure s that of Burger and Udell's (1998) fnancal growth cycle model. Many other researchers have found that specfc attrbutes of small frms mpact the types of funds used to fnance the frm's operatons (Romano, et al., 2001). However, the Burger and Udell (1998) work, whch proposes that optmal captal structures vary at specfc ponts, seems to have captured the alternaton of most researchers. 1 Department of Accountancy & Fnance, Sabaragamuwa Unversty of Sr Lanka, Sr Lanka. Emal: lmcsmenke@gmal.com

2 Menke, L.M.C.S 55 Further, Burger and Udell (1998) document that changes n optmal captal structure are a functon of the frm sze, age, and nformaton avalablty. Myers (1984) and Myers and Majut (1984) presented the concept of optmal captal structure based on the Peckng Order Theory (POT) whch suggests that frms wll ntally rely on nternally generated funds, then they wll turn to debt fnance f addtonal funds are needed and fnally they wll ssue equty to cover any remanng captal requrements 2. Dscussons on the captal structure of SMEs have ncluded ndustry effect as a determnant of captal structure (Hall et al., 2000, Johnsen and McMahon, 2005). Abor (2007) fnds that SMEs captal structure vares across ndustres and those ndustres wth hgh collateral value are often capable of attractng more long-term debt. Much of the attenton on growth n the SMEs has focused on captal relatng to fnancng are domnant n the small and young frms (Terpostra et al., 1993). Most of the researchers have found that nadequate fnancal resources as a prmary cause of SME falure (Coleman, 2000). SMEs can be dfferentated from larger frms wth respect to ther captal structure choces and they tend to rely on prvate equty markets whch constrant the form of fnancng they be able to obtan. It s wdely accepted that small frms have dfferent optmal captal structures and are fnanced by varous sources at dfferent stages of ther organzatonal lves (Burger and Udell, 1998). Ths study attempts to contrbute to the exstng lterature focusng the debate on captal structure and fnancng behavor of SMEs from a developng country perspectve and examnes the captal structure and fnancng patterns 3 that represents by Sr Lankan SMEs based on Peckng Order Theory and Lfe Cycle Model. However, there s a lack of such studes n Sr Lankan context, partcularly n SMEs. Therefore, ths study attempts to fll ths gap n the fnance lterature addressng the research queston, "How does the Peckng Order Theory and Lfe Cycle Theory of busness fnancng appear to explan fnancal structure of SMEs?" The study s organzed as follows; Secton 2 s devoted to a revew of the lterature that examnes how theores of captal structure can be appled n the context of small and medum sze enterprses. Secton 3 dscusses the data and methodology whle secton 4 presents the results and dscussons. The last secton concludes the paper. 2. Revew of Lterature 2.1 Relevance of POT for SMEs Intally, the POT requred generally explanng the observed fnancng practces of large publcly traded corporatons. However, soon after t was realzed that the theory may also apply to the fnancng practces of nonpublcly traded SMEs that mght not have the possblty of acqurng an addtonal fnancng by ssung external equty fnance. Scherr et al. (1990) consder the POT to be an approprate descrpton of SMEs' fnancng practces, because the Peckng order hypothess s n keepng wth the pror fndngs that debt s by far the largest source of external fnance for small busness. In addton, Holmes and Kent (1991) suggest that n SMEs, managers tend to be the busness owners and they do not normally want to dlute ther ownershp clam. Hall et al. (2000), argue that the nformaton asymmetry and agency problems arsng between owner-managers and outsde nvestors provdng external fnance whch gve rse to the POT are more lkely to arse n dealngs wth small enterprses because of ther "close" nature,.e. beng controlled by one person or a few, related people, and ther havng fewer dsclosure requrements. Ang (1991) provdes an alternatve to ths constraned POT, proposng a modfed peckng order of fnancng preferences for SMEs 4. Fama and French (2002) reveal a stan n the applcaton of the POT to SMEs n those less levered non-payers of dvdends are more proftable, whch s consstent wth the peckng order model. But less levered non-payers also have better nvestments. Helwage and Lang (1996) propose that the probablty of obtanng outsde fund s not related to a shortfall n nternally generated funds, whch s contrast wth predctons of the peckng order theory. Further, they document that the frms accessng the captal market do not follow a peckng order when choosng the type of securty to offer. 2 The order of preferences reflects the relatve costs of varous fnancng optons and that frms would prefer nternal sources to costly external fnance. The POT suggests that the use of external funds s very much related to proftablty on the bass that SMEs, especally f these are not lsted, wll make use of nternally generated funds as a frst resort. 3 Small frm owners wll try to meet ther fnance needs from a peckng order of frst, ther own money, second, short term borrowng thrd longer term debt and least preferred to all from the ntroducton of new equty nvestors; whch represents maxmum ntruson (Cosh and Hugher, 1994). 4 Ths nvolves new captal contrbutons from owners rankng behnd nternal fnance, but n front of debt fnance.

3 56 Journal of Small Busness and Entrepreneurshp Development, Vol. 3(1), June 2015 Shyan Sunder and Myers (1999) conclude that the peckng order theory s an excellent frst-order descrptor of corporate fnancng behavor n ther sample of mature US frms. Frank and Goyal (2003) confrm the POT whch s found among large frms n US. Hgh growth frms consstently use less debt fnancng (Barclay and Smth, 2005). Cassar and Holmes (2003) suggest that asset structure, proftablty, and growth are mportant determnants of captal structure and fnancng n Australan frms. Lemmon and Zender (2004) emprcally examned the mpact of debt capacty consderatons on fnancng decsons n a peckng order framework. Usng a sample smlar to Frank and Goyal (2003), they show that the peckng order theory s a good predctor of fnancng behavor. Bhard and Lucey (2006) appled multple regresson analyss to test the applcablty of POT to SMEs and found relatonshp between age, sze, sector, growth opportuntes and the means of collateral used to secure debt fnancng. Zoppa and McMahon (2002) examne the peckng order theory of busness fnancng n 871 manufacturng SMEs and reported that the manufacturng SMEs follow peckng order fnancng behavor. 2.2 Lfe Cycle Theory and SME Fnancng Behavor The most wdely accepted vew of the small busness captal structure s that of Berger and Udell's (1998) fnancal Lfe Cycle Model 5. Gregory et al. (2005) emprcally test the fnancal growth cycle model for SMEs n US and ther results partally support the LCT. Specfcally, ther results show that larger frms, as measured by total number of employees, are more lkely to use publc equty fundng or long-term debt as opposed to nsder fnancng. Accordng to Tmmons (2004), small, young frms tend to draw captal from nternal sources, personal sources, nformal nvestment and famly, and frends. Bhared and Lucey (2006) found that larger frms have a greater relance on the fxed assets of the enterprse to overcome the problem of nformaton asymmetry and to secure ther debt fnancng n Irsh frms. 2.3 Emprcal Evdence on Industry and SME Fnancng Behavor Many peces of research have been conducted to examne the ndustry effect on the fnancng behavor of SMEs n varous countres. Cressy and Olofsson (1997) state that manufacturng frms have large nvestment needs n machnery and hard' assets, and thus have greater access to fxed, collateralzable assets. Thus, they wll have greater access to tradtonal loan fnancng. Mchaelas et al. (1999) examned 3500 UK small frms representng ten ndustres and they suggest that n all ndustres examned the ndustry effect s more pronounced on short-term debt ratos compared to long-term debt ratos. The dfference between the magntude of the ndustry effect on short term and long term debt vares across ndustres. Hall et al. (2000) employ the same database and same number of busnesses as Mchaelas et al. (1999) and report smlar results suggestng that the wholesale and retal trade ndustry on average uses very lttle long-term debt and that the educaton, health, and socal work ndustry uses almost equal amount of short term and long term debt. Lopex- Garca and Aybar Aras (2000) examne 1000 Spansh SMEs and suggest a sgnfcant nfluence of ndustry on short-term debt revealng that frm sze s an mportant nfluence on fnancal behavor. However, the ndustry s not a sgnfcant predctor of debt as a source of fnancng n Australan famly busnesses (Romano et al., 2001). Gbson (2001, 2002) n hs study used fve dstrct clusters of SMEs based on key fundng sources: trade credt, debt, bank loan, related person debt, other debt and equty and workng owner equty and found that trade credt debt cluster s assocated wth the wholesale and the retal trade sectors. Johnsen and McMahon, (2005) study the cross-ndustry dfferences n SME fnancng behavor n Australan context by employng logstc regresson model and document that ndustry does not smply process for one or more of other factors (age, sze, proftablty, growth, asset structure of frms) but s an mportant nfluence n ts own rght. 3. Research Methodology 3.1 Research Data The study nvestgated the determnants of captal structure choces for the SMEs n Sr Lanka usng 300 SMEs. The sample selecton was based on a stratfed random desgn wth respect to sze and urban or rural locaton. The frms were then ntervewed by admnsterng a self-structured questonnare and all the frms ncluded n the sample fulfll several crtera 6. Thus, the fnal sample conssted of 300 SMEs and a survey was carred out. The survey questonnare conssts of two parts. 5 The model states that as frms become older and larger they wll tend to use more outsde sources of funds. On the other hand as frms become older, more experenced and more nformaton ally transparent t lkely to access to Captal Market. 6 The SMEs were all started before 2007 and none of them was started durng the perod , persons engaged s more than 2 and less than 250 and SMEs that are about to go bankrupt or have gone bankrupt were omtted.

4 Menke, L.M.C.S 57 Part I of the questonnare conssts of the dentfcaton of the frm and the respondents and further, the frms' characterstcs, namely frm sze, age, ownershp, assets structure, Research & Development costs (growth of the frm), varous captal structure measures; Long-term debt (LTD), short term debt (STD), nternal fnance (IF), external fnance (EF), nternal collateral (INCOL), external collateral (EXCOL), nformaton asymmetry and ndustry n whch the frm belongs to. Part II asks for the general opnon on fnancal nstruments and respondents' concrete opnon on the mportance and frequency of use of each partcular fnancal nstrument. In order to check the face valdty a peer revew was conducted wth a number of academc experts n the feld of SME research and wth some statstcans as suggested by Irena and Korner (2008) and Bhard and Lucey (2006). Next to t a plot study was conducted wth a 20 sample of enterprses from each ndustral sector n order to ensure the content valdty. Varables In order to formulate the hypotheses t was consdered a number of frm-specfc characterstcs whch nclude ndustry dfferences and owners' characterstcs such as the need for control and fnancng preferences of SME owners. The study attempts to measure the effect of these attrbutes on the captal structure decsons of the sample frms. The man components of the fnancal structure and collateral were used as dependent varables. Dependent Varables Fnancng behavor was captured separately usng fve dependent varables: long-term debts, nternal fnance, external fnance, nternal collateral and external collateral. Followng Bhard and Lucey (2006) three dfferent captal structure measures and two means of collaterals to examne the nfluences of seven explanatory varables on dependent varables were employed. SMEs n Sr Lanka are not publcly held and, therefore, not subject to the publc dsclosure regulatons of Securtes & Exchange Commsson of Sr Lanka. Further, SMEs often do not have audted fnancal statements. Thus, SMEs n Sr Lanka s nformatonally opaque as predcted by Berger and Udell (1998). As a result of lack of nformaton, data for each of the dependent varable could not be collected contnuously over perods. Therefore, all dependent varables took the form of bnary (whether the partcular fnancal nstrument or mean of collateral s used, 1 for "yes" and 0 for "no"). Independent Varables Burger and Udell (1998) suggest that as frms become older and larger they wll tend to use more outsde sources of captal. Further, they contend that ths effect wll also occur as more fnancal nformaton becomes avalable on a frm. Therefore, the researcher tres to measure the determnants of captal structure over tme and the ndependent varables of nterest were frm age, frm sze, the growth opportuntes, assets structure, ownershp and nformaton asymmetry (the amount of fnancal nformaton avalable on the frm). The ndustry has an nfluence on fnancng decson of SMEs (Johnsen et al., 2005). Therefore, the study nvestgated the sgnfcance of the ndustry as an ndependent varable and used four dummy varables to capture the whole ndustral sectors 7. All the ndependent varables were defned as follows; AGE = Age of the frm at the tme of the survey (Three levels, less than 5, 5 to 14 and greater or equal to 15 years) (f < 10 "0", f ³ 10, "1") SIZE = Number of employees at the tme of the survey. Two levels, less than 10 or greater or equal to 10 OWN = Closely held ownershp of frm (wthn the famly) (Dchotomous dummy varable, yes = 1, no = 0) ASSETS STRUCTURE = Collateral fxed assets as a percentage of total fnancng. R&D = Amount nvested as research and development costs. Dummy varables, (yes = 1, no = 0) INFORMATION ASYMMETRY = The amount of fnancal nformaton avalable on the frm (Dchotomous dummy varable, yes = 1, no = 0) METAL = Metal manufacturng and engneerng ndustry FOOD = Food, beverages, and tobacco TEXTILE = Textle, wearng, apparel and leather WOOD = Wood, wood product and furnture 7 All the sectors were categorzed nto fve man categores.

5 58 Journal of Small Busness and Entrepreneurshp Development, Vol. 3(1), June 2015 OTHER = Paper products, prntng and publshng, petroleum, rubber and plastc, Nonmetallc and mneral products and others 3.3 Development of Hypotheses A number of researchers have provded emprcal evdence suggestng that the POT explans the captal structure choce of SMEs (Hogan and Hutson, 2005; Irena and Korner, 2008 and Bhard and Lucey, 2006). Therefore, based on the theoretcal and emprcal evdence revewed on peckng order theory and the Lfe cycle theory the researcher formulates the followng hypotheses: H1: Age wll be postvely related wth the use of nternal equty. H2: Closely held famly frms wll have a hgher relance on nternal equty. H3: There s a postve relaton between frms wth a greater amount of collateralzable fxed assets and long-term debt fnancng. H4: There s a negatve relaton between frms wth a greater amount of collateralzable fxed assets and use of external equty. H5: Larger frms, as measured by the number of employees are more lkely to use long-term debts. H6: Use of external equty wll be postvely related to growth optons. H7: Use of nternal equty wll be negatvely related to growth optons. H8: Use of external equty wll be hgher n younger frms. H9: Age and use of long-term debt are postvely related. H10: Younger frms wll have a greater relance on the personal assets of the SME owner to secure debt fnancng. H11: Larger frms wll rely on the assets of the frm as collateral for debt fnancng. H12: Collateral provded by the fxed assets of the busness wll be postvely related to frm sze. H13: Collateral provded by the personal assets of the SME owner wll be negatvely related wth the frm sze. H14: Collateral provded by the fxed assets of the busness wll be postvely related wth frms wth a greater amount of collateralzable fxed assets. H15: Collateral provded by the fxed assets of the busness wll be postvely related wth frms wth a greater amount of ntangble assets (growth optons). H16: SMEs n certan ndustres are more lkely to use nternal fnance. 3.4 Emprcal Model and Estmaton Procedure The study attempts to explore whether the Peckng Order Theory and Lfe Cycle Theory are appled to the captal structure decsons of SMEs. The analytcal model for ths study, derved from the pror research revewed earler, s as llustrated n equaton 1. The model nclude, represents age, sze, ownershp, asset structure, nformaton asymmetry, growth optons and ndustry, are lkely to nfluence the captal structures of SMEs. The bnary logstc model takes the followng verbal form, Dependent varable (0,1) = constant+ AGE + SIZE + AS + IAS + OWN+ R&D+INDUSTRY The key study relatonshp for the same can be represented n the followng form, P log t( P) log 0 1Age1 2 Age2 3Sze 4 AS 5IAS 1 P OWN R & D IND1 IND2 IND3 IND4 6 7 Where; Age1 = 1 f Age of the frm < 5 Age2 = 1 f Age of the frm s 5-14 Sze = 1 f Sze of the frm 10 Own = 1 famly R&D = 1 f the frm spend money for R&D (1)

6 Menke, L.M.C.S 59 IND 1 = 1 f the frm s METAL IND2 = 1 f the frm s FOOD IND2 = 1 f the frm s TEXTILE IND3 = 1 f the frm s WOOD The analytcal tool used for ths study allows for a bnary dependent varable and the testng of the hypotheses formulated applyng logstc regresson analyss, ncludng the lnear probablty model. Lnear functons are nherently unbounded whle probabltes are bounded by 0 and 1. Ths makes the logt analyss, the most obvous canddates for the regresson analyss of dchotomous varables. Ths model always returns values between 0 and Results and Dscusson 4.1 Long-term Debt Fnance and Independent Varables Ths study emprcally tests the wdely acclamed Berger and Udell (1998) Lfe Cycle Model and Myers (1984) Peckng Order Hypothess of busness fnancng. The frst bnary logstc regresson modelng undertaken employed a dchotomous dependent varable ndcatng whether the long -term debts s used or not by the SMEs n the sample.. Smple logstc regressons were run for each ndependent varable separately. Results of the nsgnfcant varables are not presented here for brevty. The results from ths modelng effort are represented n Table 01. Table 01: Parameter Estmates, Standard Errors, P Values, Exp(Β), Probablty wth logstc regresson model for the Influencng Factors for usng Long-terms Debt Varable Model Parameter S.E. P Value Exp(β) Probablty Reference Category Logt(P )= β 0 + <5 Age + β Age Age β 0 = <5 = Age group β = Logt(P )= β Sze Sze β 0 = < = Sze Logt(P )= β 0 + Asset Structure Asset Structure (fxed assets as a percentage of total assets) β 0 = = Logt(P)= β0 + β1 <5 Age + β Age + β3 Asset Structure + β4 10 Sze Age, Asset Structure, Sze β0 = Age >15, β = Asset Structure, hgh proportons β1 <5 = Sze < 10 β3 AS = β4 10 = The results show that younger frms whose age s between 5-15 years are more lkely to use long-term debts wth a 47% probablty of usng long-term debts. Ths s statstcally sgnfcant and provdes a support for H9. Larger frms, as measured by employees, are more lkely to use long-term debts. SMEs wth more than 10 employees (larger frms) have a 50% probablty of usng long-term debts whch are statstcally sgnfcant provdng a great support for H5. SMEs wth hgher proporton of fxed assets have a 21% probablty of usng long-term debts than other SMEs who do not possess hgher proporton of fxed assets, because they tend to access to tradtonal loan captal wth a greater amount of collateralzable fxed assets. Ths fndng s statstcally sgnfcant and provdes a greater support for H3. The multple logstc regresson model was ftted wth sgnfcant varables and s statstcally sgnfcant and ncludes three varables assocated wth the use of long-term loans. There s a 40% probablty of usng long-term loans by large sze, younger SMEs wth a greater amount of collateralzable fxed assets than other SMEs whose sze s small and older wth a less amount of collateralzable fxed assets wth adjustng for other factors.

7 60 Journal of Small Busness and Entrepreneurshp Development, Vol. 3(1), June Internal Fnance and Independent Varables The second logstc regresson model (Table 02) tests the use of nternal fnance (funds from famly, own money, funds from frends and relatves) wth a number of ndependent varables 8. Table 02: Parameter Estmates, Standard Errors, P Values, Exp(Β), Probablty wth logstc regresson model for the Influencng Factors for usng Internal Fnance Varable Model Parameter S.E. P Value Exp(β) Probablty Reference Category Logt(P )= β 0 + Research & Development cost Research & β 0 = No Development cost Yes = Logt(P )= β 0 + Metal + β 2 Food + β 3 Textle + β 4 Wood Industry β 0 = Other Industres Metal= β 2 Food = β 3 Textle = β 4 Wood = Logt(P)= β0 + β1 Metal + β2 Food + β3 Textle + β4 Wood + β5 Research & Development cost Industry, Research & Development β0 = Other Industres, Research & Development Cost - No β1 Metal = β2 Food = β3 Textle = β4 Wood = β5 R&D Yes = The smple logstc regresson results show that the frms wth a hgh proporton of spendng on research and development (R & D) have 85% probablty of usng nternal fnance to meet ther fundng needs whle other SMEs who do not spend for R & D have a 70% probablty. Ths fndng s statstcally sgnfcant and provdes a great support for H7. On the other hand, frms wth a hgher proporton of fxed assets, namely METAL and WOOD product frms are sgnfcantly more lkely to use (the probablty 62% and 68% respectvely) nternal fnance, opposed to the frms engage n other ndustres suggestng support for H16. The results of the ftted multple logstc regresson show three sgnfcant varables assocated wth the use of nternal fnance to fund ther nvestments needs. Frms operate n METAL ndustry and spend money on R & D or more growth frms have a 60% probablty of usng nternal fnance. SMEs that spend money on R & D and operate n the WOOD products ndustry have a 68% probablty of usng nternal funds. 4.3 External Fnance and Independent Varables The model 3 (Table 03) tests the probablty of usng external fnance wth ndependent varables. It s found that the frm age s a predctor of captal structure decsons and had a strong relatonshp as proposed by Berger and Udell (1998). The results mply that younger frms as opposed to older frms are more lkely to use external funds (eg. trade credts, funds from outsders and outsde debts.) as older frms are no longer demonstratng growth and are less lkely to attract outsde captal. The fndng s statstcally sgnfcant and the probablty of usng external fnance s 66% n younger frms, hence, we accept H8. The results also reveal that closely held frms (OWN1) have a 58% probablty of usng external funds whch gve a contradctory result as opposed to the hypotheszed result, hence we reject H2. 8 The model (smple logstc regresson) estmates the probablty of usng nternal fnance wth each of the ndependent varables separately. Fnally, a separate multple logstc regresson was run ncludng all sgnfcant ndependent varables.

8 Menke, L.M.C.S 61 Table 03: Parameter Estmates, Standard Errors, P Values, Exp(Β), Probablty wth logstc regresson model for the Influencng Factors for usng External Fnance Varable Model Parameter S.E. P Value Exp(β) Probablty Reference Category Logt(P )= β 0 + <5 Age + β Age Age β 0 = <5 <5 = Age Group β = Logt(P )= β 0 + Ownershp Ownershp β 0 = No Yes = Logt(P )= β 0 + Ownershp + β 2 >5 Age + β Age Ownershp, Age group β 0 = <5 Age Group Ownershp = β 2 >5 Age = Age = The results of multple logstc regresson whch examnes the probablty of usng external funds wth age and ownershp of SMEs, show statstcally sgnfcant relatonshps. Younger and closely held famly frms have 69% probablty of accessng external funds whle start-up and older frms whch do not operate by famly members have 26% probablty of usng external funds Internal Collateral and Independent Varables Model 4 nvestgates the assocaton between the use of fxed assets of the busness to secure debt fnancng (INCOL) and the ndependent varables. The summary statstcs of the ftted smple and multple logstc regresson s reported n Table 04. The results reveal that larger frms, as measured by the number of employees, are more lkely to use frm's fxed assets as collaterals to secure debt fnancng provdng support for H11. Table 04: Parameter Estmates, Standard Errors, P Values, Exp(Β), Probablty wth logstc regresson model for the Influencng Factors for usng Internal Collateral Varable Model Parameter S.E. P Value Exp(β) Probablty Reference Category Logt(P)= β0 + β1 10 Sze Sze β0 = <10 β1 <10 = Sze Logt(P)= β0 + β1 Research & Development cost Research & Development β0 = No β1 Yes = Logt(P)= β0 + β1 Informaton Asymmetry Informaton Asymmetry β0 = No β1 Yes = Logt(P)= β0 + β1 Metal + β2 Food + β3 Textle + β4 Wood Industry β0 = β1 Metal = Other Industry β2 Food = β3 Textle = β4 Wood = Logt(P)= β0 + β1 Metal + β2 Food + β3 Textle + β4 Wood + β5 Research & Development cost + β6 Informaton Asymmetrc Industry, sze, research & development, Informaton asymmetry β0 = β1 Metal = Other Industry β2 Food = β3 Textle = β4 Wood = β5 Sze = β6 R&D = β7 IAS = More growth frms are more lkely to use nternal collaterals as hypotheszed and the probablty s 22% as opposed to 11% probablty of fewer growth frms, suggestng a support for H15. More nformatonally transparent SMEs have a hgher probablty of 23% of usng fxed assets of the busness as collaterals to secure debts whereas less nformatonally transparent frms demonstrate 11% probablty. Ths fndng s statstcally sgnfcant and provdes a strong support for H14.

9 62 Journal of Small Busness and Entrepreneurshp Development, Vol. 3(1), June 2015 An SME beng n the FOOD product ndustry s more lkely to use fxed assets of the busness as collaterals compared to other ndustres. The multple logstc regresson model ftted wth four sgnfcant varables show strong relatonshps between the use of nternal collateral and the four ndependent varables namely, sze, R & D, IAS and FOOD products ndustry. More nformally transparent, large sze, hgh growth SMEs who operate n FOOD products have a 60% probablty of usng frm's fxed assets as collaterals to secure debt fnancng whle other frms, fewer growth frms wth small sze, operate n METAL, TEXTILE, WOOD and OTHERs have a 9% probablty of usng fxed assets of the frm as collaterals. 4.5 External Collaterals and Independent Varables The model 6 examnes the relatonshp between the personal assets of the SME owner provded as collateral for frm debt and the ndependent varables. The summary statstcs of the ftted regresson s shown n Table 05. The results show that large sze SMEs are more lkely to use personal assets of the owner as collaterals to secure loan fnancng wth a statstcally sgnfcant assocaton. Ths result s contradctory wth the hypotheszed sgn of negatve relaton hence; there s no evdence to accept H13. Ths suggests that even frms have adequate collateralzable assets they provde personal assets to secure debt fnancng. SMEs engage n FOOD and TEXTILE ndustres are more lkely to use external collaterals to secure debts whch are also statstcally sgnfcant. Table 05: Parameter Estmates, Standard Errors, P Values, Exp (Β), Probablty wth logstc regresson model for the Influencng Factors for usng External Collaterals Varable Model Parameter S.E. P Value Exp(β) Probablty Reference Category Logt(P )= β Sze Sze β 0 = <10 <10 = Sze Logt(P )= β 0 + Metal + β 2 Food + β 3 Textle + β 4 Wood Industry β 0 = Other Industry Metal = β 2 Food = β 3 Textle = β 4 Wood = Logt(P )= β 0 + Metal + β 2 Food + β 3 Textle + β 4 Wood + β 5 10 Sze Industry, sze β 0 = Other ndustry Metal = β 2 Food = β 3 Textle = β 4 Wood = β 5 l 10 = The results of the multple logstc regresson reveal mportant determnants of the frms' use of external collaterals for debt fnancng. An SME beng n the food products ndustry wth large sze whch employs 10 or more employees have a 40% probablty of usng personal assets as collaterals whle SMEs whch operate n TEXTILE ndustry wth large sze have a much hgher probablty of 50%. On the other hand, SMEs n METAL, WOOD and OTHER ndustres wth small sze have an 11% probablty of usng owners' personal assets as collaterals. 4.6 Descrptve Analyss In order to provde further lght on the fndngs from the logstc regresson analyss a qualtatve analyss was conducted. The summary of answers of the respondents to a number of questons and statements whch were presented n three pont Lkert scales s reported n Table Fnancng Preferences of the Owners The frst queston of the second part of the questonnare asked a number of drect statements to test whether the fnancng preferences follow a peckng order. Out of total 88% of the respondents reported a clear preference for usng nternal cash flows/ retaned profts to fund ther nvestment needs. A number of comments on completed survey forms are reterated as follows; Most of our fnancal needs are met out of retaned profts We are self fnancng and requrng no debt or outsde sources. Almost all the frms n the sample are prvately owned and sole traders and partnershp frms.

10 Menke, L.M.C.S 63 Among all respondents 95% the frms demonstrate an averson not to convert ther busnesses to company form of organzatons. The reason that the respondents commonly cted for the observed fnancng preferences of SME owners s the desre for ndependence and to mantan control of the enterprse. They have stated that they wshed to retan the ownershp of the busness for the founders. The answers to the queston of future fundng requrements revealed that 70% of respondents sought fundng to facltate expanson, whle, 18% requred addtonal captal for workng captal. The remanng 12% requred addtonal fundng for a new venture. Ths fndng suggests that where addtonal funds are requred, ther man purpose s for nvestment n exstng and new assets. Table 06: Fnancng Preferences of Respondents N= 300 Agree Nether Agree or Dsagree 1. Prefer to use retaned profts as much as possble 88% 6% 6% 2. Long-term bank loans would sut by nvestment needs 55% 10% 35% 3. Addtonal fundng would sut my; - Investment needs - Workng captal needs - For startng new ventures 70% 18% 12% Prefer to convert nto company form of organzatons - 5% 95% Source: Survey Data Dsagree Almost all the respondents stated that bank loans would sut ther nvestment needs. There are sgnfcant sectoral dfferences n responses to ths statement.e., frms n the METAL and WOOD ndustry generally prefer to use nternal cash flows n the frst nstance followed by debts. The other ndustres appear to devate from ths peckng order of fnancng Informaton Asymmetres The respondents perceptons on the questons relatng to nformaton asymmetry n the debt market are shown n Table 07. Almost 55% of respondents are wth the percepton that banks understand ther busnesses very well. On the other hand 92% of respondents state that banks are wllng to provde overdraft facltes to ther busnesses. Almost 87% of respondents perceve that fnancal nsttutons nsst on collateral to secure debt fnancng. Table 07: Respondents Perceptons on Sources of Fnance Agree Nether Agree or Dsagree Dsagree 1. Banks understand my busness well 55% 11% 44% 2. Banks are wllng to provde overdraft facltes 92% 2% 6% 3. Loan provders nsst on collateral 87% 5% 8% Source: Survey Data 5. Concluson Ths study analyzed the captal structure and the means of collateral on whch debt fnancng s succeeded, to test the applcablty of POT and LCT of SME fnancng n Sr Lanka. The smple and multple logstc regresson results show strong support for the POT and LCT. Enterprse sze, as measured by total employment, s postvely related wth the use of LTD. The mplcaton s that the larger an SME n terms of employment, the more lkely t wll depend upon long-term debt fnancng. Ths suggests that larger frms tend to acqure loans, decrease nformaton asymmetry provdng fxed assets as collaterals. Further, t can be concluded that the younger an SME s, and therefore, the less tme t has had to become self-suffcent through renvestment of profts, the more lkely to t wll need to depend upon long-term debt fnancng for ts assets and actvtes. The hgher the proporton of fxed assets held by an SME, the more lkely t wll be that t depends upon long-term debt fnancng for ts assets. In overall the fndngs appear to be consstent wth the POT of busness fnancng (Myers, 1984).

11 64 Journal of Small Busness and Entrepreneurshp Development, Vol. 3(1), June 2015 Snce the large sze younger frms have become large enough to accumulate tangble fxed assets by elmnatng nformal asymmetry, they tend to acqure loan captal provdng fxed assets as collaterals. When they become older, they accumulate more profts by renvestng and ther borrowng requrements declne over tme as retaned earnngs are accumulated. So, ths s consstent wth LCT of Burger and Udell (1998). On the other hand, these fndngs are consstent wth the fndngs by Bhard and Lucey (2006), Cassar and Holmes (2003), Mchaelas et al. (1999). The ownershp structure s negatvely assocated wth external fnance and postvely related to nternal fnance, confrmng the well-recognzed desre for ndependence and control of closely held famly frms. Ths evdence s consstent wth POT and fndngs by Bhard and Lucey (2006). Hgh growth frms use hgher levels of nternal equty suggestng that these frms typcally have suffcent nternal fnance to meet ther nvestment needs. Ths s nconsstent wth the fndngs of Cressy and Olofsson (1997) that the owners of frms seekng to grow are less averse to cedng control than those not seekng growth. Younger frms are more lkely to use external fnance snce those accumulate tangble fxed assets over tme and they can show a track record. Thus, they can overcome asymmetrc nformaton and can access to loan captal and trade credt etc. Means of collateral to secure debt fnancng shows that larger sze, hgh growth frms wth nformaton asymmetry have a greater relance on the fxed assets of the busness to overcome the problem of nformaton asymmetry and to secure debt fnancng whch shows a consstent result wth Bhard and Lucey (2006). Large sze SMEs are more lkely to provde personal assets as collaterals even they have adequate busness assets to secure debt fnancng. SMEs n the FOOD ndustry have a greater relance on personal assets whle frms n the TEXTILE ndustry have a greater relance on busness assets to provde as collaterals to secure loan captal. Beng the SMEs n METAL and WOOD ndustres are less lkely to use nternal fnance whle the SME n TEXTILE ndustry s more lkely to use long-term debts. All these frms possess substantal fxed assets to provde as collaterals to pledge as securtes. The qualtatve analyss reveals that ther motves for fnancng preferences, frst for nternal and next for debt fnancng, are a desre for ndependence and control and a percepton of a lack of nformaton asymmetres n debt markets. These fnancng preferences of SME owners follow the Peckng Order Theory (POT) as proposed by Myers (1984). On the other hand ths fndng s consstent wth Berger and Udell (1998), who propose that fnancal, needs and optons change as the busness growth, gans further experences, and become less nformatonally opaque. Implcatons The fndngs of ths research wll gve practcal mplcatons for polcy makers and SME owners/ managers. SMEs owners/ managers can operate ther busnesses by targetng the optmum debt/ equty levels at each stage of ther growth. Informaton asymmetry s hgh at the nfant stage and two years after the commencement of the busness nternal sources of funds are possble. Frms become larger, older and more nformatonally transparent ther fnancng optons become more attractve and frms should gan access to captal market or long-term debt fnancng. Therefore, at ths stage of growth they should try to accumulate adequate retaned earnngs n order to fnance ther nvestment needs or they should access to rase long-term loans snce the nformaton asymmetry s dsappeared at ths stage. The polcy makers should provde an envronment n whch owner/ managers are able to retan suffcent profts n ther busnesses to fund the largest possble number of economcally vable projects. Further, the fscal polces should concentrate on provdng ncentves to retan profts and encourage nvestments n growth-orented strateges. References Abeyratne S. (2005). Small and Medum Enterprses n Sr Lanka: Integratng the SME Sector wth the Market, Regonal Conventon of Polcy Reforms for SME Development n SAARC Countres, 2-3 Dec., Colombo, Sr Lanka. Abor J. (2007). Industry Classfcaton and the Captal Structure of Ghanaan SMEs, Studes n Economcs and Fnance, Vol. 24 No. 3, pp Ang, J. S. (1991). 'On the Theory of Fnance for Prvately Held Frms.' The Journal of Small Busness Fnance, Vol. 4, Nos2 & 3, pp Barclay, M.J. and Smth, C.W. (2005). The captal structure puzzle: the evdence revsted, Journal of Appled Corporate Fnance, Vol. 17 No. 1, pp Berger, A. N. and G. F. Udell (1998). 'The Economcs of Small Busness Fnance: The Roles of Prvate Equty and Debt Markets n the Fnancal Growth Cycle.' Journal of Bankng and Fnance, Vol. 22, (1998), pp

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