Financing working capital requirements and financial risk-taking in SMEs

What the paper says

Purpose The objective of this study is to analyze the effects of working capital requirement (WCR) financing strategies on SMEs' financial risk. Our main research question is: does a greater use of short-term debt to finance WCR increase financial risk-taking? Design/methodology/approach We use two variables previously used in the literature – FWCR, to measure WC financing strategy, and SD_ROE, to measure financial risk-taking- and conduct econometric analyses using fixed effects and two-way clustering methods to control for heterogeneity. We also control for other factors that may affect financial risk, as per the literature. Findings The results of this study indicate a linear relationship between the proportion of WCR financed with short-term debt and financial risk since more aggressive financing strategies, that is with a higher proportion of short-term debt, imply higher financial risk. The main hypothesis is confirmed for the entire sample and individually for the vast majority of industries. In addition, it has been verified that the instability of cash generation impacts the choice of WCR funding strategy, as these factors may lead to greater financial risk-taking. Practical implications Once the economic structure has been defined and the need for financial resources to finance WCR arises, managers must consider their financial structure and choose the strategy that fits their risk-taking tolerance. Using short-term financing without considering the firm's risk profile could destroy value, especially when sales fluctuations affect the firm's economic structure and add uncertainty and instability to cash generation. Moreover, creditors can analyze a firm's financing WCR strategy to discuss debt terms such as length, rates or potential covenants depending on the strategy, since firms with more aggressive strategies have more financial risk, which leads to solvency problems. Originality/value This work contributes to the literature on WCR management in several ways. On the one hand, it explores a topic that has not received enough attention in the literature on working capital: the relationship between WCR financing and its risk. To the best of our knowledge, this is the first article to highlight the effects of WCR financing strategy on SME financial risk in the financial literature. As it focuses on SMEs, which are the backbone of the economy, the issue addressed is particularly important.