Factors Affecting the Probability of SME Bankruptcy:

A Case Study on New Zealand Unlisted Firms

By
Nirosha Hewa Wellalage and Stuart Locke
University of Waikato, Hamilton, New Zealand
Abstract
This study investigates the potential relationship between bankruptcy risks, and financial and
non-financial characteristics in small businesses. Given the importance of small businesses
to a countrys economy, identifying factors that leads to small business bankruptcy is
important for assisting policy makers and businesses. Using logistic regression analysis this
study finds that that bankruptcy firms appear to be non-franchised (independent) with fewer
inside ownership. The bankruptcy risk for larger firms in major cities is less than smaller
firms from rural areas. Further findings suggest bankruptcy risk in small businesses relates to
the industrial sector in which a firm finds itself. This evidence proves that the declining
economic health is not the only reason for small business bankruptcy. Further, this paper
extends our understanding of how increasing the management adequacy through employment
training leads to the higher survival rate of small firms.
Keywords: Small firms, bankruptcy, firm ownership and firm characteristics
1. Introduction
The small business sector is important for all economies, contributing significantly to
employment and gross domestic product (GDP). As an example, in 2009 small and medium
enterprises (SMEs) contributed 41.9% of the countrys GDP and approximately one third of
total employment in New Zealand (SMEs in New Zealand, 2010). Despite their importance
to a countrys economy, failures and bankruptcy are all too frequent. According to Peacock
(2000) the high failure rate is a fundamental characteristic in small firms which separate them
from large firms. In 2009 in New Zealand there were more SME deaths than births (SMEs in
New Zealand: Structure and Dynamics, 2010) and survival rates for smaller firms are
significantly less than for larger firms. As an example, only 31% of zero employee firms set

Electronic copy available at: http://ssrn.com/abstract=2073794

up in 2001 survived until 2009. Small business bankruptcy is disruptive and very costly to
owners and their families.
Alongside direct costs, bankruptcy generates huge indirect costs for small business owners;
including loss of self esteem, personal collateral and self employment. Based on US and
Canadian findings SMEs bankruptcy is not always not necessarily attributable to ability to
access financial sources. Peacock (2000) found that poor management leads to a high rate of
failures in small businesses.

He notes that 92% of US SMEs and 96% of Canadian SMEs

fail due to management reason. Due to the small size, most SMEs depend on one ownermanager, whose skills may not cover all the management areas needed.
Few studies have focused on factors leading to SME bankruptcy. Using a financial ratios to
predict bankruptcy of US SMEs Altman and Sabato (2007) concluded that SMEs financial
ratios have significant impact in determining SMEs bankruptcy. Recently Madrid-Guijarroa,
et al. (2011) analysed non-financial factors associate with SMEs failures in Spain
manufacturing industry. However, the main goal of this study is to analyse the both financial
ratios and firm specific non-financial factors impact on SMEs bankruptcy.

Due to the

significance of small business to a countrys economy, identifying factors that impact small
business bankruptcy is important. This study adds to the empirical evidence concerning firm
characteristics and firm bankruptcy risk. Most existing studies use data from large listed
companies, but it is important to consider the links between unlisted businesses and firm
characteristics on firm bankruptcy. This study uses the most recent datasets period in New
Zealand, 2008, whereas prior studies covered mostly US or UK firms and spanned only a few
months.

This research may be useful for understanding the development of the most

successful internal governance mechanisms for small business survival.

By examining

bankruptcies in small business; this paper will extend our understanding of increase
management adequacy through employment training leads higher survival rate of small firms.
2

Electronic copy available at: http://ssrn.com/abstract=2073794

The next section of the paper reviews prior research and presents the hypotheses. This is
followed by a discussion of the data, variables, method and procedures used for this empirical
study. Then results, conclusion and implications are presented.
2. Literature review
Identifying the reason for small business failure and measuring it is difficult for many reasons.
However, the consequences of small business failure are bankrupt. Carter and Auken (2006)
identified these as lack of knowledge, inaccessibility of debts and economic climate as
significant factors contributing to small business bankruptcy. They also identified firm age
and industry type as influencing SME bankruptcy. Altman and Sabato (2007) found there is a
significant relationship between SME failures and their financial ratios in the U.S context.
However, until recently, predicting bankruptcy in SMEs has not attracted much international
attention due to a lack of available data and structural differences in small business sectors
(Yoon and Kwon, 2010).
Hypothesis development
Insider ownership is most common in small businesses and is prevalent as an internal control
mechanism. Fiche and Slezak (2008) found a significant negative relationship between
insider ownership and bankruptcy hazards, indicating that insider ownership is more effective
in avoiding bankruptcy once financial distress is indicated. It may be that higher insider
ownership helps to reduce asymmetric information problems in small businesses (Ross, 1973).
Another reason for the negative relationship between insider ownership percentage and SME
bankruptcy probability is that small firm owner-managers have their human capital tied to the
firm.

Therefore, they typically have an incentive to reduce bankruptcy risk.

This is

confirmed by Gopalan et al. (2004), who find that percentage of insider holding has
significant negative impact on Indian firm bankruptcies. Parker et al. (2002) investigated
corporate governance characteristics and survival likelihood of distressed firms and found
3

Electronic copy available at: http://ssrn.com/abstract=2073794

higher insider ownership positively affects the survival likelihood of distressed firms.
Therefore, the first hypothesis that has been formulated regarding insider ownership and a
firm bankruptcy risk in unlisted business is:
H1: A higher proportion of insider ownership negatively affects smaller firm bankruptcy
According to the conventional wisdom, franchising start-up is safe for small business
owners, because the franchisor provides high finance accessibility, managerial assistance and
new market access through the parent firm.

The British Franchise Association (BFA)

explains that the success rate as a franchisee is five times higher than for independent small
businesses (BFA, 1996). Further, based on a survey of US small firms Kostecka (1988)
found that less than 4% of franchise SMEs fail each year. There it appears there are some
benefits to starting a franchise format rather than a small independent firm. Based on a
resource scarcity argument, Stanworth (1998) suggests that franchising is a means of faster
expansion and survival, because franchises provide capital, knowledge of local markets and
technology. In a study of 45 franchised small firms and 50 non franchised small firms
Ibrahim (1985), found that franchising was one solution to reduce small business failure.
This is consistent with Teece (1986) who explains via franchising firms can access limited
co-specialised assets.

Based on US franchised and non-franchised firm Shane (1996),

indicates the hybrid management of franchised firms eliminate potential agency problems of
adverse selection and moral hazards of managers. Due to low levels of agency conflict,
franchised firms reduce their monitoring costs and enhance profitability and survival rate. A
testable hypothesis regarding the firm ownership type (franchise or independent) and
bankruptcy risk in small business is:
H2: Franchise firms have a lower possibility of bankruptcy than independent small firms

Prior research has found that the size of firm is a significant factor determining for firm
bankruptcy. Early studies by McConell and Pettit (1984) and Pettit and Singer (1985) found
a negative relationship between firm size and bankruptcy risks. Gill et al. (2009) explains
that due to larger firms being more diversified and having more stable cash flows, the
probability of bankruptcy is less than for small firms. Larger firms are usually more stable
with greater credibility and assets. They are less likely to be getting into bankrupt than small
ones. Small firms may have the negative effects of information gaps, lack of knowledge,
inaccessibility to debt and other factors.

Therefore, the next hypothesis that has been

formulated regarding firm size and firm bankruptcy risk in unlisted businesses:
H3: Firm size is negatively associated with small firms bankruptcy risk
Fifty three percent of small and medium sized enterprises (SMEs) in New Zealand fail
within the first three years (Mason, 2010). As a firm matures, technology adaptation, degree
of diversification and expertise in the management team gradually increase (Campa and
Kedia, 2002; Villalonga, 2004). These factors may increase the survival rate of mature
businesses.

Thornhill and Ami (2003) explain the young firms failure may due to

inadequate resources and capabilities. This indicates young firms face the critical challenge
of generating positive cash flows in the early years due to lack of resources and capabilities.
This leads to the ultimate bankruptcy of young firms.

Consistent with above findings

Kalleberg and Leicht (1991), Phillips and Kirchoff (1989) found mature firms have lower
bankruptcy rates than young firms. Therefore, the fourth hypothesis that has been formulated
regarding firm age and firm bankruptcy risk is:
H4: Firm age is negatively associated with small firms bankruptcy risk
Firm accounting ratios have significant impact on SMEs bankruptcy. In the absence of capital
market data, the time banking generally an sector use accounting ratios based model for
5

predicting bankruptcy in small firms (Altman &Sabato 2007;Baixauli &Mdica-Milo 2010).

Firm profitability is a critical element, since prior studies have shown that capital markets are
concerned about the ability for debt repayment of firms and profitability is a key sign of debt
repayment ability. Muller and Baker III (1997) used US data to explain that the pattern of
the Altmans Z score mirrors the firm ROA pattern. Bever et al. (2005), using NYSE data
found that the mean ROA of non bankruptcy firms is relatively higher than that on the
bankruptcy firms and the bankrupt firms ROA decreased over the four years prior to
bankruptcy.

Consistent with above findings Millar and Chen (2004) found a negative

relationship between firm ROA and bankruptcy risk.

significant impact on SMEs bankruptcy.

Next, firm leverage ratio also has

Not surprisingly, under-leveraged is a major

challenge in SMEs all over the world. This may be because access to external financing is
critical to small firms (Kang, et al. 2008). The firms high leveraged ratio indicates the
firms accessibility to external financing. Hence, a high leverage ratio indicates the low
probability of SMEs bankruptcy. The next hypothesis that has been formulated regarding
firm financial ratios and firm bankruptcy risk is:
H5: Firm financial ratios are significantly associated with small firms bankruptcy risk.
SMEs in New Zealand: Structure and Dynamics (2010) reports that SMEs, in the mining,
education, training, healthcare and social assistance industries are less likely to remain in
businesses for six years or more. Prior studies indicate that industry effect is an important
component in determining bankruptcy. Chava and Jarrow (2004) give two reasons for
bankruptcy risk varying among industries. The first reason is the level of competition; which
varies from industry to industry. The second reason is accounting conventions; different
industries may have different accounting conventions. Using 57 bankrupt small businesses
Carter and Aukeen (2006), found that significant industry effect in small firms bankruptcy.
Further, they found bankrupt firms are more likely to be in the retail industry.

Nordal and
6

Naes (2010) used Norwegian non listed firms for the period of 1988- 2007 and found that the
construction industry positively and significantly affects bankruptcy in non-listed firms.
Therefore, the next hypothesis, regarding industry type and firm bankruptcy risk is:
H6: Industry type is significantly associated with small firms bankruptcy risk.
A US survey of business indicated that for most businesses, the selection of location is a
critical decision in determining bankruptcy (Bradlelly, 2004). According to SMEs in New
Zealand: Structure and Dynamics (2009), the highest number of SMEs are found in large
urban cities. Brinkman et al. (2010) found US firms located in urban areas are mature and
larger than firms located in rural areas. Furthermore, competitors, customers, suppliers vary
upon location.

From a marketing point of view, population density, local competitors

strength, foot and vehicular traffic need to be considered when selecting a business location.
Therefore, the next hypothesis is formulated regarding firm location and firm bankruptcy risk
in unlisted businesses:
H7: Firm geographical location is significantly associated with small firms bankruptcy risk
3. Methodology
Data and sample selection
A random sample of 100 bankrupt firms and 100 non-bankrupt firms were drawn from the
annual survey conducted by the Management Research Centre at the University of Waikato.
The data are collected annually in conjunction with the New Zealand Institute of Chartered
Accountants as part of a financial benchmarking reporting programme. The total time series
reaches back to 1982. This study selected only the year 2008, because economic conditions
can have significant impact on bankruptcy or takeovers and voluntary exits over a range of
years.

According to the OECD report in 2009, there is increase in reported defaults,

insolvency and bankruptcies in most OECD countries SMEs due to global crisis in the year
7

2008. However, small business shows high voluntary exit rate or takeovers in global financial
crisis period.

Therefore, differentiating bankruptcy from voluntary exit is important.

Nevertheless, following prior studies this paper defines bankruptcy firms that are insolvent
and already recognised in a formal bankruptcy procedure. Firms included in the study
represent a range of industries categorised as primary, energy, goods, services, and other.
Table I
Descriptive statistics
Variable
Insider ownership (OWNER)
LnOWNER

Obs
200
200

Mean
44.00389
3.453714

Std. Dev.
34.08427
. 9684299

Min
0
-. 6780336

Max
100
4.60517

Franchise (FRANCHISE)

200

0.05950

0.23663

Location (LOCATION1)

200

. 1950413

. 3963963

Location (LOCATION2)

200

. 2041322

. 4032327

Location (LOCATION3)

200

. 2181818

. 4131823

Location (LOCATION4)

200

. 3826446

. 4862336

Industry (INDUSTRY1)

200

.2

. 4001654

Industry (INDUSTRY2)

200

.2

. 4001654

Industry (INDUSTRY3)

200

.2

. 4001654

Industry (INDUSTRY4)

200

.2

. 4001654

Industry (INDUSTRY5)

200

.2

. 4001654

Employees (SIZE)

200

7.863802

16.72171

96

200

1.441753

1.296933

-3.506558

5.278115

200

8.02316

3.921134

25

200

1.926897

. 6187388

3.218876

Liquidity (LIQUIDITY)

200

2.90884

8.99493

25.4431

Leverage (LEVERAGE)

200

0.8753707

1.548331

0.003868

36.0442

ROA

200

3.345745

3.5943

0.008483

46.9057

LNSIZE
AGE
LNAGE

The mean value of insider ownership is 44%, the highest percentage of insider ownership is
100% and lowest insider ownership representation is 0%. This is consistent with the view
8

that insider ownership is prevalent in smaller business. About 6% of sample represents

franchise firms. This may be most of the SME sector is represented by micro-firms and they
are sole-proprietorship and not going for franchise. The sample firms ROA mean is 3.4.
About 20% of firms are located in Auckland, the largest urban city. The next 20% of firms
are located in four other large urban cities and 38% of firms from rural areas.

The study

sample consists of equal percentages of (20%) firms from primary, energy, good, service and
other industries. The mean number of employees is 8, the highest number is 96 and lowest is
0. The mean year of firm age is 8; the oldest firm age is 25 years and the youngest is 1 year
old. Study shows the average leverage ratio is significantly high at 0.87 and the sample
firms ROA mean is 3.4. This finding is consisting with Klapper, Sarria-Allende, and Sulla
(2002) who using Eastern and Central European SMEs find that SMEs are highly leveraged
and highly profitable compared to their larger counterparts.
Variables and measures
Dependent variable
Firm bankruptcy is a binary variable (BANK) that takes a value of one when a firms it is in
the default category and zero otherwise (surviving firms).
Explanatory variables
The firm ownership structure is analysed by two main dimensions, noting that as an
unincorporated business there is no share ownership. Insider working ownership (OWNER)
and ownership type (i.e. franchise or independent ownership). The working owner (OWNER)
percentage is calculated as the number of working owners divided by total staff plus number
of working owners.

The next variable is ownership type (FRANCHISE). I the firm

ownership is a franchise then FRANCHISE equals 1, and 0 when the firm is independent.
Geographic location (LOCATION) included as 4 dummy variables based on the city/town
where the business is located. For industry type the study divides all firms into five major
9

categories and uses as industry dummy to capture industry-specific characteristics.

LOCATION1 is equal to 1, if a firm is from the largest urban city. LOCALTION2 is equal to
1, if the firm is from any other of the four main cities. LOCATION3 is equal to 1, if the firm
is from other cities. Finally, LOCATION4 is equal to 1, if the firm is from a rural area.
Based on the industry type, the study divides all firms into five major categories (excluding
manufacturing firms) and uses as industry dummy (INDUSTRY) to capture industry-specific
characteristics.

INDUSTRY1 is equal to 1, if the firm is from primary industry.

INDUSTRY2 is equal to 1, if the firm is from the energy industry. INDUSTRY3 is equal to
1, if the firm is from good(s) industry. INDUSTRY4 is equal to 1, if the firm is from a
service industry. Finally, INDUSTRY5 is equal to 1, if the firm is from other industry.
Similar to previous studies, some control variables are included in the estimated model. The
first control variable is Firm size (LNSIZE) measured by the natural logarithm of total
employees. Further, log of firm age (LNAGE) is included as control variables. Following
Altman and Sabato (2007) this study include three ratios as accounting ratios, which show
significant impact in US SMEs failures. LEVERAGE ratio is calculated as total debt to total
assets. LIQUIDITY ratio is calculated as total current assets to total current liabilities. ROA
is calculated as net income to total assets.
Method
When the dependent variable is binary, most assumptions in linear regression are violating.
Therefore, it needs to use logistic regression which does not make any assumptions of
normality, linearity and homoscedasticy of independent variables. Bankruptcy is measured on
an ordinal scale, and hence ordered probit or logit models would be an appropriate
econometric technique. Such models have been used in prior bankruptcy research (Ohlson,
1980, Daily and Dalton, 1994, Bernhardsen, 2001).

This study proposes to clarify the

10

dependent variable as dichotomous being either bankruptcy or non bankruptcy and hence
used logistic regression model.
4. Results
Figure1,

depicts

kernel

density

estimators

of

OWNER,

LNSIZE,

LNAGE,

LIQUIDITY,LEVERAGE and ROA for bankruptcy firms and survival firms. The difference
between bankruptcy and solvent firms is clearly visible. Therefore, figure 1 suggests the need
to address the issue of potential bankruptcy and firm characteristics.
Figure 1: Kernel density estimators of financial and non-financial variables for bankrupt
(dashed line) and survive (solid line) firms sparely

Liquidity
1.5

.6

Leverage
Survive
Bankruptcy

.5

.2

Density

Density

.4

Survive
Bankruptcy

50

100

150

200

250

10

20
Leverage

Liquidity
kernel = epanechnikov, bandwidth = 0.3695

30

40

kernel = epanechnikov, bandwidth = 0.1164

Firm Size
.4

.015

Working Owner

Survive
Bankrupt

.2

Density

.1

.005

Density

.01

.3

Survive
Bankruptcy

20

40
60
Working owner%

80

100

-4

-2

lnsize

ke rne l = epanechnikov, bandwi dth = 7.6423

ke rne l = epanechnikov, bandwi dth = 0.2856

Firm ROA
.8

Firm Age

Survive
Bankruptcy

.2

.4

Density

.4

.2
0

Density

.6

.6

.8

Survive
Bankruptcy

ke rne l = epanechnikov, bandwi dth = 0.1342

2
lnage

-5

5
lnroa

10

15

ke rne l = epanechnikov, bandwi dth = 0.1394

11

Table II presents the results of the logistic regression analysis.

Table II
Results of logistic analysis
Variable

Coefficient

Std. Err

Const.

-12.20081***

1.312309

OWNER

-.0177445**

.0085524

-1.325113 ***

.4696219

LOCATION2

-.5101154 *

.2925543

LOCATION3

-.2078576

.2832566

LOCATION4

-.0912315

.2558647

INDUSTRY1

-.0695221

.3354288

INDUSTRY2

1.073221***

.3281209

INDUSTRY3

.5655885*

.3222641

INDUSTRY4

.9581847**

.3150911

SIZE

-1.030564***

.1770991

LNAGE

.1261223

.1507676

LIQUIDITY

-.2053551**

0.0833489

LEVERAGE

3.218557***

0.726504

ROA

2.227506***

.2921533

Number of obs = 200

FRANCHISE
LOCATION1

INDUSTRY5

rho

0.056265

Likihood-ratio test of rho=0;chibar2 (01) = 2.66 prob>= chibar2=0.052

This model provides standard errors which are in parentheses. , * Significant at 10% level, **Significant at 5% level, ** *Significant at 1%
level

The coefficient of OWNER variable is negatively and statistically significant at 5% level for
the bankruptcy variable. The negative coefficient indicates that the close monitoring by
insider owners tends to decrease bankruptcy risk. This result is in agreement with numerous
studies and depicts the importance of equity ownership and aligns the interest of firm

12

managers and owners as survival mechanisms for small businesses (Yermack, 1996;
McConnel and Servaes, 1990).
Consideration of the FRANCHISE variable, in Table II, reveals that it is negatively related
to bankruptcy at the 1% significance level, indicating an independent firms bankruptcy
possibility is higher than franchise firms. This is consistent with Padmanabhan (1986) who
concluded that franchise firms fail generally less often than independent firms.
Sophistication of management practices, infrastructure availability and a franchised brand
name may positively affect the higher survival rate of franchised firms over independent
firms.
Firm size has a negative effect on bankruptcy prediction variables, at 1% significance level,
indicating smaller firms have higher bankruptcy possibility than their larger counterparts.
This finding is consistent with Dichev (1998) who finds a negative correlation with firm size
and bankruptcy risk. This may be because large firms have higher access to more external
and internal finance than small firms. Large firms also have diversified human capital.
Next it is noted that industry factors play an important role in bankruptcy risk. This
observation is similar to Chava and Jarrow (2004) who found that industry groups are
significantly affected in bankruptcy hazard forecasting in US contexts. Results indicate that
firms operating in the energy industry have a high possibility of bankruptcy more than the
other four selected industries. This may be due to different competitor levels and capital
structure differences among industries. It can be seen from Table II that firm bankruptcy
probability is related to locations.

Four larger urban cities (LOCATION2) significantly

negatively related to bankruptcy, indicating that bankruptcy is more likely in firms from rural
areas and other cities than in firms from larger urban cities. Lack of market availability and

13

less population density may be the reasons for rural firm bankruptcy probability being higher
than urban small firms.
Finally study finds that accounting ratios have significant impact of SMEs bankruptcy.
The coefficient of profitability variable is 1% significantly negatively related to SME
bankruptcy indicates, more profitable firms have high survival rate than relatively low
profitable firms. Next liquidity variable is 5% significantly negatively related to small firms
bankruptcy indicates highly liquidity firms have less probability of bankruptcy. This may be,
because firms with high liquidity ratio indicates their greater ability to meet short-term debt
obligations (Al-Najjar 2009). Consistent with Shumway (2001), Uhrig-Homburg (2005),
Campbell et al. (2008) and Eberhart et al (2008), this study finds a negative relationship with
bankruptcy possibility and firm ROA, indicating high profitability firms have less probability
of bankruptcy. It may be that high performance SMEs have more retained profit which they
can use to raise debt when additional financing is required. Finally, not surprisingly this
study shows leverage ratio has 1% significant positive relationship on firms bankruptcy.
5. Conclusion and implications
The research indicates that bankruptcy risks are presented in small business and in many
instances these findings are consistent with prior research for listed businesses.

The

importance of studies on bankruptcy in small businesses is apparent because of high failure

rates in small business in most of the countries. Therefore, polices, regulations and new
company strategies need to be developed to reduce SMEs bankruptcy risks. The, the current
New Zealand bankruptcy law does not provide any special exceptions for small business
bankruptcy. The US bankruptcy law provides two important protections for small business
owners; owners future earnings are exempt from the obligation to repay debt and have a
homestead exemption. If such initiatives are introduced the small business sector would be
able to provide the maximum possible contribution to economic growth.
14

Insider ownership seems to be a determinant of firm bankruptcy risk. Firms with higher
insider ownership are less likely to fail than firms with less insider ownership.

The

requirement for well developed internal corporate governance mechanisms and reducing the
agency problem will potentially reduce bankruptcy risks in small firms. This study raises the
potential for regulatory and policy reforms that may enhance survival in the sector.
The results show that the bankrupt firms are more likely to be operating as independent
firms rather than franchised firms. This indicates the competitive strength of the vertically
organised network. In a vibrant small business sector, especially in an economic distress
period, franchising holds offers many of the advantages of belonging to a larger chain.
According to Cross (1994), failures factors that leads to be reduced by franchising, such as
undercapitalisation, absence of economies of scale and lack of business insight.
6. Limitations
Notwithstanding the findings, the current study suffers from the following limitations, which
would potentially represent opportunities for further investigations. First, while this paper
has provided useful insights into firm ownership, firm characteristics and bankruptcy risks in
unlisted businesses the findings are based on research in a single country. Secondly, several
changes in the tax system during the sample period are likely to have affected firms financial
ratios. This study did not consider tax changing effects for financial ratios when calculating
the bankruptcy risk factor.
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