Financial market imperfections and profitability: New evidence from a large panel of US SME firms

• Date: 01 March 2020
• Published date: 01 March 2020
• DOI: http://doi.org/10.1002/for.2623
• Author: Nicholas Apergis

RESEARCH ARTICLE

Financial market imperfections and profitability: New

evidence from a large panel of US SME firms

Nicholas Apergis

1,2

1

Department of Banking and Financial

Management, University of Piraeus,

Piraeus, Greece

2

Department of Social Science, University

of Derby, Derby, UK

Correspondence

Nicholas Apergis, Department of Banking

and Financial Management, University of

Piraeus, 80 M. Karaoli & A. Dimitriou St.,

18534, Piraeus, Greece

Email: napergis@unipi.gr

Abstract

This paper investigates the impact of financial market imperfections on small

and medium‐sized enterprise (SME) firms' profitability by using a unique panel

data of US SME firms, spanning the period 1979–2017. The data set makes use

of unique information on proxies of market imperfections pertaining to each

firm in the sample. First, the findings document the statistical impact of those

financial market imperfections on profitability. Moreover, the forecasting exer-

cise illustrate the superiority of the model that explicitly includes those proxies.

KEYWORDS

market imperfections, profitability, SME firms, USA

1|INTRODUCTION

The goal of this paper is to explore the role of financial

market imperfections on small and medium‐sized enter-

prise (SME) firms' profitability by using a panel data set

containing specific information on US SME firms, span-

ning the period 1979–2017. While there is substantial the-

oretical and empirical literature analyzing the role of

financial constraints or financial development on firms'

profitability and investment activities (Kaplan & Zingales,

1997; Levine, 2005), there are still limited papers that

consider how profitability and investments are affected

by the contemporaneous presence of other market imper-

fections. More specifically, certain studies analyze invest-

ment decisions in the contemporaneous presence of

product, labor, and financial market imperfections

(Biosca, 2010; Calcagnini, Ferrando, & Giombini, 2013;

Calcagnini, Giombini, & Saltari, 2009; Cingano, Leonardi,

Messina, & Pica, 2010). This literature documents that

market regulations hamper profitability and, in turn,

investment, while the interactions between labor, prod-

uct, and financial markets show that in the presence of

more efficient financial markets the (indirect) negative

impact of market regulations on firms' profitability and

investment is lower. However, our study is focusing only

on financial markets' imperfections, while the author

plans to extend it with respect to the other types of imper-

fections in a future research venue.

The main novelty of this work comes through the data

set that contains information on finance market imper-

fections pertaining to each firm in the sample, while it

exhausts all potential combinations coming from alterna-

tive definitions of both the dependent and the indepen-

dent variables. SMEs are as innovative as large‐scale

enterprises (Davis & Haltiwanger, 1992). A financial envi-

ronment that supports SME growth is an indispensable

condition for the success of small businesses. By exten-

sion, inadequate access to external finance, both for

domestic and foreign investments, improperly hampers

economic growth and welfare. This work focuses on

SME firms because of the substantial asymmetric infor-

mation problems that are often present in small firms.

In that sense, adverse selection and moral hazard may

cause SMEs to be confronted with significant financing

gaps. The access to public capital markets is often not

available for SMEs, while the traditional private finan-

ciers—venture capitalists and banks—are often reluctant

to provide financing. These financing issues potentially

hinder SMEs in exploiting their full growth potential,

which has an adverse impact on their profitability. In

addition, SMEs are more constrained in the use of control

mechanisms as collateral, long‐term relationship, and

Received: 22 January 2019 Revised: 20 May 2019 Accepted: 12 July 2019

DOI: 10.1002/for.2623

Journal of Forecasting. 2020;39:220–241.wileyonlinelibrary.com/journal/for© 2019 John Wiley & Sons, Ltd.220

reputation than large firms to ease information problems

(Scholtens, 1999). As small firms are limited in the extent

of their internal earnings and in their potential to issue

equity, they depend more on bank loans. Based on infor-

mation coming from various reports from the Federal

Deposit Insurance Corporation (FDIC), the statistics

show that over 80% of SME firms in the USA turn to bank

and nonbank credit to get financing for their activities.

Moreover, credit usually comes as small business loans

as the amount of currently outstanding commercial and

industrial loans with original amounts less than

$1,000,000 held at domestic bank offices. However,

regarding bank loans, SMEs find themselves again in a

deprived position compared to large firms as ex ante, as

well as ex post, information asymmetries are more prom-

inent (Giudici & Paleari, 2000). In that sense, according to

the Community Reinvestment Act (CRA), we finally con-

sider, on average, 93% of SMEs that have received small

business loans with an amount of less than $100,000.

The literature has provided certain theories attempting

to explain the capital structure (Gill, Biger, & Mathur,

2011). It is widely reported that in the static tradeoff the-

ory of capital structure a more profitable firm is predicted

to have a higher leverage ratio (Frank & Goyal, 2005).

Firms choose the debt and equity mix by balancing the

costs and benefits. Competent managers who identify

the appropriate mix of debt and equity minimize the firm

cost of finance, maximize the profitability, and thereby

improve the competitive advantage. Different firm‐

specific strategies are implemented by the managers to

gain competitive advantages to the firm and thereby

enhance the firms' value result in performance differ-

ences (Gleason, Mathur, & Singh, 2000). Modigliani and

Miller (1958) provide the well‐known theory of irrele-

vance of capital structure, where financial leverage does

not affect the firms' market value. Modigliani and Miller

(1963) recommend that to maximize the value of firms

they should use as much debt capital as possible where

they ignore the risk. The literature suggests alternatives

to the Modigliani and Miller theory by introducing the

agency theory (Jensen & Meckling, 1976), the pecking

order theory (Myers & Mujlif, 1984), and the theory of

bankruptcy (Titman, 1984).

The paper touches two major strands of the literature.

The first is associated with the determinants of SME profit-

ability. There is a vast literature here, while a number of

papers are provided later in the section where the variables

included are described. Important studies in the literature

are those by Barney (2001), Cowling (2004), and

Davidsson, Steffens, and Fitzsimmons (2009), among

others. A most related strand of the literature is, however,

the one that explicitly explores the role of financial market

imperfections for SMEs. More specifically, the majority of

SMEs rely on internal sources, such as personal savings

or retained earnings, to fund their investment, and only a

small proportion have tried to obtain finance from external

sources (Cosh, Cumming, & Hughes, 2009; Cowling, Liu,

& Ledger, 2012). However, the supply of external finance

to SMEs differs fundamentally from larger firms in the

sense that private debt and equity markets are the only

markets that SMEs have access to whereas larger firms

have access to both private and public markets. The most

common source of external funding is commercial banks

(Colombo & Grilli, 2007). Yet not all SMEs that apply for

external credit are successful (Cowling et al., 2012; Fairlie

& Robb, 2007). Furthermore, smaller, younger (start‐ups)

and high‐growth firms (Cowling et al., 2012; Fraser,

Bhaumik, & Wright, 2015), together with firms with rela-

tively inexperienced, poorer educated, and ethnic minority

entrepreneurs (Fraser, 2009), are more likely to have diffi-

culties in accessing external finance. In addition, prior

research has shown that the utilization of financing instru-

ments by SMEs depends on various firm‐and product‐

specific characteristics such as firm size, firm age, owner-

ship structure or innovativeness of firms, and the industry

in which they operate (Degryse, de Goeij, & Kappert, 2012)

and their macroeconomic, financial, and legal environ-

ment (Beck, Demirguc‐Kunt, & Maksimovic, 2008). How-

ever, there are only a few studies that integrate the

different determinants and the various financing instru-

ments available to SMEs into a single and comprehensive

empirical analysis (Beck et al., 2008; Casey & O'Toole,

2014). These studies, however, make use of aggregate

indexes to gauge the role of financial market imperfections

in firm performance. Our study taps into this literature gap

by taking a more holistic perspective. In particular, it

explicitly considers such financial imperfections and mea-

sures pertaining to each firm in our sample. Our work is

close to the study by Ferrando and Ruggieri (2018), who

also employ a firm‐specific indicator of financial con-

straints using a classification based on specific firm charac-

teristics and various measures of financial pressure and

liquidity. They apply this indicator to a firm‐level produc-

tion equation to assess the direct impact of access to

finance on firm‐level productivity. Their findings docu-

ment the presence of significant and negative effects in

the majority of sectors across countries. This impact

appears to be significantly higher in sectors like Energy,

Gas and Water Supply, and R&D, Communication, and

Information, for small and micro firms, whereas it is

slightly smaller for firms with positive investment rates.

The results strongly indicated that financial market

imperfections not only hamper profitability, but also the

forecastability of such profitability is enhanced when the

modeling approach explicitly considers the variability of

such imperfections. The findings survived a number of

APERGIS 221