SMEs Failure

Diplomarbeit von Marc P. Philipp

Abstract:

During the last decades, small and medium-sized enterprises (SMEs) have been one of the major driving forces of worldwide economic growth, employment and prosperity. Moreover, they are considered to be of high importance in ensuring a friction-free adaptation to economical, technological, and social changes. Especially European economies, foremost Germany being the third largest economy in the world, highly depend on this class of companies as important contributors to the increase of living standards, productivity and competitiveness. As Hommel & Schneider (2003) conclude, any structural problem affecting this mass of economic 'backbone' businesses is thus likely to cause macroeconomic frictions to an economy as a whole Vice versa, it seems reasonable to argue that negative macro-level economic performance can be easily caused by an underperforming SME sector.

A glance at the current business environment gives evidence that SMEs are navigating in a dramatic time of economic turmoil: Corporate bankruptcy in Germany e.g. has more than doubled during the last 10 years to a record level of almost 40,000 filed cases in 2003. Bankruptcy rates (i.e. 'Insolvenzquote') have raised to a peak in 2001 since the 1980's - a level, which has not been touched even in times of economic downturn within the last 15 years.

The near future of many European SMEs is embossed by big threats and opportunities triggered by the upcoming EU member extension in May 2004, which will provide easy market access to SMEs from 10 East European, Baltic, and Mediterranean countries. As more than 35% of all German SMEs are not engaged outside Germany, the opportunity of gaining access to new sales markets could easily be dominated by impending competition threats an the price dimension in German regional markets.

One might think that with respect to economic theory business failure is „a problem that may not exist (or may be overrated)“, as a certain level of failure would be expected in a competitive environment, due to mechanisms of resource allocation and the replacement of inefficient firms. However, such a large scale of corporate bankruptcies causes dramatic costs to an economy, as not all liabilities can be paid back by an insolvent firm. Moreover, indirect economic losses can occur, e.g. due to the destruction of established stakeholder relationships, and temporary „vacuums“ in certain markets. Business failure thus is a central issue not only in business research, but also in economics and social sciences. Since the early work of Fritzpatrick (1931), bankruptcies have always gained attention of individual academics. As a result of the magnitude of the consequences it has an employment and economic welfare, business failure continues to perceive increasing attention also from economic authorities and practitioners. Especially banks and other financial institutions require effective failure and bankruptcy prediction tools to assess the risk involved in their credit portfolio. This issue is likely to become even more severe, especially in Germany, as the worldwide consolidation process in the banking industry progresses and certain players are required to appear attractive for possible acquisitions.

During the last 30 years, the exponential evolution of informatics, mathematics, and statistical techniques has amplified empirical research, resulting in a large and heterogeneous number of many hundred papers analyzing business failure. Surprisingly, the issue has remained unresolved in the theoretic realm: Up to today, it was not possible to develop an exhaustive theory of business failure, in spite of a few notable efforts.

Moreover, the vast majority of finance and management research in this field has been dealing with large and publicly traded enterprises, as (a) the scale of their debt positions is generally higher and research often is motivated by a credit-risk perspective, (b) there is more financial and internal data available, and (c) large firm failures gain more publicity than the mass of SME failures. Thus, intrinsic characteristics of the SME sector are often neglected and not integrated into the theoretical background when hypotheses are formulated and research methodologies are chosen. Therefore, the objective of this paper is to elaborate an how SMEs fail, by what these failures are triggered (i.e. what are potential causes of such failures), and which symptoms exist. As corporate crises are still often identified too Tate to initiate effective corrective actions, the aim is thus to give useful insights to prospective entrepreneurs, SME managers, and key stakeholders such as capital providers. The paper employs the specific characteristics of the SME sector to discuss the different dimensions of business failure and its potential indicators. Furthermore, it wants to show how empirical research in this field works and how it has (or has not) contributed to the explanation of the 'failure phenomenon'. By pointing out the theoretical gaps in research, important problems and tradeoffs, the paper wants to develop possible solutions for how they could be closed. With that, a fundament should be laid for improving future models an SMEs failure explanation, prediction, and prevention.

Research Methodology and Scope:

To ensure a systematic understanding of the relationships and interdependencies among the different issues concerning the complex phenomenon of SMEs failure, the paper is following a top-down approach. Hereby, the general focus lies an failure's symptoms and indicators, as their identification is vital for failure prediction and prevention.

First and following these introductory remarks, a broad overview of the SME sector is given in chapter 2. This is important for the further proceeding, as it provides the basis for later arguments and implications. With respect to the scope of the paper, a regional focus is set an the European, but especially an the German SME sector.

Second, the phenomenon of business failure is analyzed. This is important as one wants to derive a proxy measure for business failure, which pragmatic and theoretically correct. The paper clusters the different failure dimensions used in literature into two groups, static and dynamic, which are presented and evaluated in chapter 3.1 and 3.2.

Third, the explanation and prediction of failure strongly depends an the identification of theoretically correct and empirically significant symptoms, which then can be employed as indicators in prediction models. Hence, chapter 4 introduces the general research design used in literature, presents key empirical findings, and critically evaluates them. Subsequently, the available theoretical background is going to be presented. The paper hereby primarily focuses an the research approach mostly used in literature, which is ratio analysis. Moreover, the statistical techniques used in this Field are briefly explained, but are not the scope of this paper. The critical evaluation focuses more an the empirical research's findings and its theoretical underpinning.

Fourth, to build the bridge from failure prediction to failure prevention, one has to analyze the underlying causes for distress, which is elaborated in chapter 5.

Finally, chapter 6 draws a conclusion and gives an outlook, which should serve as a stimulus for further research by identifying open issues in this field.

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