The problem of financial constraints seems to extend beyond the problem of appropriability or innovation. This third study tries to find the factors beyond the firm’s purviewthat may affect firm’s financial choices. It extends the study of capital structure of firms to accommodate regional financial characteristics that are generally discussed in the banking literature. Until recently, the two research streams dealing with financing of firms, access to finance and capital structure, have been distinct from each other. Faulkender and Petersen (2006) unite these two in an effort to show that supply of capital is as important as demand for capital in determining capital structure choice of firms. It is still an open issue whether this result is applicable to small firms. This study addresses this issue by empirically testing the effect of regional presence of lending institutions on different financing options and their combinations utilized by small and medium sized firms (SME).
While failure of many small firms can be attributed to the lack of credit availability, composition of firm’s finances also plays a crucial role. The small firm capital structure research focuses on this point. Small firms need not respond to market assessments (Chaganti et al., 1995) and therefore could choose to finance themselves with the sources they deem to find useful or obtainable. Also, Romano et al. (2001) rightly note that the dynamic interplay between business characteristics and behavioral characteristics is important in financing decisions.
Earlier work on financial structure concentrated mainly on owner, firm, and industry characteristics in the premise of information asymmetries, agency costs, and signaling. Only recently the concentration has shifted to the specific sources of capital. Faulkender and Petersen (2006, p.46) add that “the same type of market frictions that make capital structure relevant (information asymmetry and investment distortions) also imply that firms sometimes are rationed by their lenders.” This indicates at the financial constraints the firm’s face and “thus, when estimating a firm’s leverage it is important to include not only the determinants of its preferred leverage (the demand side) but also the variables that measure the constraints on a firm’s ability to increase its leverage (the supply side).”
While the demand factors may say that small firms resist equity and use mainly internal finance or combine with other financing choices, the supply factors such as availability of financial institutions in the region may in the first place determine the composition of capital structure. If the quantity channel on the regional level is working, then firms will tend to combinemore sources of finance that are debt-based or utilize the services of a lending institution – ceteris paribus. The same effect may be possible from the price channel (through interest rates etc). Considering small firms, the financial structure takes a wider form including bootstrap financing (asset based lending, factoring, leasing). Most of these are lending technologies and need a presence of a lending institution. Hence, firms may tend to combine these with internal finance if the quantity or price channels are not in operation.
This study empirically tests for the effect of regional presence of lending institutions on different financing options utilized by SMEs. To do so this paper introduces amodifiedmeasure of lending operational distance – “commercial operational distance.” This measure is calculated for both local as well as national lending institutions. Overall, the analysis is performed for two levels: rural and urban. The central question is how regional commercial operational distance affects the usage and combination of financing sources with traditional sources of finance.
Compiling together a dataset of almost 2,000 SMEs in England with regional lending institution data, the results show that the presence of very local lending institutions affects the likelihood of urban small firms to combine retained earnings with only debt or debt and boot strap or debt, bootstrap and equity. These combinations are not utilized by small firms that are in the regions where banks and semi-local lending institutions exist. They would rather depend on internal financing. For rural small firms, the presence of lending institutions does not matter. In fact, high presence of any lending institution does not change the preference for internal finance. Also, the effect of quantity channel when all lending institutions are present in a region was tested. High combined presence also does not deter small firms from using internal finance both in rural and urban areas. The two reasons for these are that small firms may rely on internal finance as the quantity and price channels of lending institutions do not seem to work and if they do work its only for very local lending institutions.
The second reason might be that due to riskier firms approaching for debt, monitoring costs are pushed on to the borrower or credit rationing might trigger usage of internal finance only. In the case of small firms, Faulkender and Petersen (2006)’s proposition that usage of debt will increase with increase in suppliers of capital stands true only with respect to increase in very local suppliers of finance and not with all.
