SMES External Financing Preference and Its Impact on Growth

Abstract

As firms go about their operations and expand their activities, the retained earnings of the firm might prove insufficient to support its activities. Firms are forced to look for external finance and the ordeal lies with how to raise the needed funds. A financial contract design for small firms is chosen on the basis of the financial characteristics of the firm, the entrepreneur, the firm’s prospects and the associated information problems (Berger & Udell, 1998). Broadly, these factors that play a crucial role in determining the financial contract type (debt or equity) can be categorized into three. The firm characteristics which combine the financial characteristics of the firm and the firm’s prospects. The other categories are owner characteristics representing the entrepreneur’s factor and the control mechanisms present to deal with the associated information problems. This thesis presents a study to examine the influence of firm characteristics, owner characteristics and control mechanisms for information asymmetry on the SMEs external financing preference and how this preference together with other firm determinants impact the growth of firms. This research was a cross-sectional study which relied solely on primary data. A binary logistic regression was used to analyze the data due to the dichotomous nature of the dependent variable- financial contract type and the objectives that needed to be achieved. The empirical results suggest that firm characteristics play an important role in influencing the external debt preference of SMEs. Both legal status and age of the firm had a positive influence on SMEs preference for debt. In addition, the sector in which an SMEs operated and its growth category had a positive influence on its preference for debt. The study suggests that SMEs follows the pecking order theory. However, this preference for debt has a negative impact on the growth of firms. Therefore, SMEs should implement internal policies on debt management and have in place proper monitoring mechanism to mitigate the adverse implication of debt and its negative impact on growth.