SME rebalancing short-term and long-term debt ratios: the role of financial distress costs

• Date: 02 December 2024
• Pages: 169-186
• DOI: https://doi.org/10.1108/IJAIM-02-2023-0034
• Published date: 02 December 2024
• Subject Matter: Accounting & finance,Accounting/accountancy,Accounting methods/systems
• Author: Zélia Serrasqueiro,Filipe Sardo,Elisabete Neves,Flávio Morais

SME rebalancing short-term and

long-term debt ratios: the role

of f‌inancial distress costs

Z

elia Serrasqueiro

Department of Management, University of Beira Interior, Covilhã, Portugal

Filipe Sardo

Department of Economics Management and Industrial Engineering,

University of Aveiro, Aveiro, Portugal

Elisabete Neves

Coimbra Business SchooljISCAC, Polytechnic Institute of Coimbra Higher

Institute of Accountancy and Administration of Coimbra, Coimbra, Portugal and

Universidade de Tras-os-Montes e Alto Douro, Vila Real, Portugal, and

Fl

avio Morais

Department of Management and Economics, University of Beira Interior, Covilha,

Portugal; Department of Management, Polytechnic Institute of Viseu, Viseu,

Portugal and University of Beira Interior Research Center in Business Sciences,

Covilha, Portugal

Abstract

Purpose –This study seeks to analyze the effect of the f‌inancial distress costson small and medium-sized

enterprises(SME) rebalancing of short-term and long-term debt ratios.

Design/methodology/approach –The authors use the system-generalizedmethod of moments (GMM-sys)

to treat data collectedfor a sample of Portuguese manufacturing SMEs for the period 2011–2017.

Findings –Financial distress costs positively impact the speed with which SMEs rebalance their short-

term and long-term debt ratios The positive effect of f‌inancial distress costs on the speed of adjustment

(SOA) is higher for the short-term than for the long-term debt ratio. This result suggests that SMEs seek to

overcome quicker the f‌inancing imbalance in the short run, probably,due totheir dependence on short-term

debt.

Practical implications –SME owners-managers should seek to relyless on short-term debt to reduce the

f‌irm default risk, the f‌inancingimbalance and the f‌inancial distress costs. Banks shouldlend long-term loans to

SMEs, given that the high f‌inancialdistress risk of these f‌irms results from their dependenceon short-term debt

f‌inancing. Policymakersshould promote SME access to external f‌inance sources with lower transaction costs,

to SME rebalancetheir capital structures.

The authors gratefully acknowledge the f‌inancial support from National Funds of the FCT –

Portuguese Foundation for Science and Technology within the projects CEFAGE UIDB/04007/2020,

NECE UIDB/04630/2020 and DOI identif‌ier 10.54499/UIDB/04630/2020, and UIDP/00681/2020,

DOI 10.54499/UIDP/00681/2020 and UIDB/05422/2020.

International

Journal of

Accounting &

Information

Management

169

Received13 February 2023

Revised 21 December 2023

28 October 2024

Accepted4 November 2024

InternationalJournal of

Accounting& Information

Management

Vol.33 No. 1, 2025

pp. 169-186

© Emerald Publishing Limited

1834-7649

DOI 10.1108/IJAIM-02-2023-0034

The current issue and full text archive of this journal is available on Emerald Insight at:

https://www.emerald.com/insight/1834-7649.htm

Originality/value –This study analyzes the effect of f‌inancial distress costs on the SOA with which SMEs

rebalance their capital structure.We estimate the f‌inancial distress costs based on a hazard model, to analyze

their effecton the SOA toward the target debt ratios.

Keywords Financial distress costs, Manufacturing SMEs, Ref‌inancing risk,

Target short-term and long-term debt ratios

Paper type Research paper

1. Introduction

Previous studies have concludedthat small and medium-sized f‌irms (SMEs) rely on retained

earnings, which exhaustion leads these f‌irms to rely on debt f‌inance. Finally, SMEs rely on

external equity to mitigate their f‌inancial needs. This hierarchical order followed in the

selection of f‌inance sources is according to the predictions of the Pecking Order theory

(POT) that is based on the problems of asymmetry between f‌irm and external f‌inanciers

(Vermoesen et al., 2013; Quintilliani, 2017; Öhman and Yazdanfar, 2017). Previous studies

show that dynamic trade-offtheory can contribute to a deeper understanding of SME capital

structure decisions. This theorystates that f‌irms have a target debt ratio, from which they can

deviate. This deviation generates deviation costs due to the f‌irm f‌inancialimbalance, which

increases f‌inancial distress costs and the f‌irm probability of bankruptcy. Therefore, f‌irms

should revert toward their target debt ratio to rebalance their capital structure. However,the

speed of adjustment (SOA) toward the target debt ratio does not depend only on deviation

costs but also on adjustment/transaction costs (hereafter, transaction costs). If the deviation

costs are inferior to transaction costs, f‌irms will reduce the SOA and will take more time to

revert toward the targetdebt ratio.

Research by Cowling et al. (2012),Dang et al. (2012) and Fitzgerald and Ryan (2019)

conclude that small f‌irms are exposed to external pressures to rebalance their capital

structures due to high deviation costs. In turn, Aybar-Arias et al. (2012) and Öztekin and

Flannery (2012) conclude that f‌inancially constrained f‌irms, like small f‌irms, face high

transaction costs, which imply a reduction in the SOA toward the target debt ratio. This

suggests that, to adjust toward the target debt ratios and avoid transactions in the capital

market, SMEs rely on f‌inancial internallygenerated resources to pay the debt. Therefore, on

the one hand, SMEs rely on internal f‌inance to adjust toward the target debt ratio. This

preference for using internal f‌inance to reverttoward the target debt level is according to the

predictions of POT. On the other hand, SMEs reverttoward their target debt ratios, which is

in accordance with the dynamic trade-off theory. Accordingly,we can conclude that POT and

dynamic trade-of theoryare complementary, in explaining SME adjustmenttoward the target

debt ratio. Various authors argue that peckingorder behavior may dominate in the short term

and the predictions of the trade-off theory may matter in the long term (De Haan and

Hinloopen, 2003;Hovakimianet al., 2004; Haan and Hinloopen; 2003; Kayhan and Titman,

2007; Haas and Marga Peeters, 2006). Titman and Tsyplakov (2007) develop a model that

shows that whereas pecking order behavior inf‌luences capital structure decision-making,

f‌irms also move toward the targetdebt ratio.

Despite the existence of high transaction costs, various studies (Cowling et al., 2012;

Dang et al.,2012;Fitzgerald and Ryan, 2019;Fitzgerald and Ryan, 2019) conclude that

small f‌irms face high f‌inancial distress costs, which force them to adjust faster toward their

target debt ratio. Therefore, SMEsseek to rebalance their debt ratios to renegotiate credit on

favorable terms, which is very important for these f‌irms due to their dependence on debt to

support f‌irm fundingneeds.

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