The determinants of the costs of financial distress in SMEs

Abstract

We propose a theoretical model that argues that the expected financial distress costs in small- and medium-sized enterprises (SMEs) result from the interaction of the financial distress likelihood and the magnitude of the consequences borne whenever financial failure occurs. The empirical evidence from five European countries, where the insolvency laws are representative of prevailing institutional traditions, supports this model. We reveal that the ex ante financial distress costs suffered by a firm depend not only on the likelihood of financial distress but also on the variables that influence the amount of time and costs incurred during the insolvency process. Specifically, financial costs are lower where the capacity to use tangible assets as collateral and short-term debt is greater; they are higher the greater the use of long-term secured debt. Additionally, the effect of these variables is moderated by a firm’s ownership and by the nature of the insolvency law in operation. The timely management of these variables can avoid the high costs involved in an involuntary exit.

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