Implication of inside-debt: signalling for bankruptcy probabilities within small firms

Purpose – Small privately held firms extensively use debt provided by principal owners and households (inside-debt) as an alternative capital source to straight equity capital. The purpose of the research study is to investigate inside-debt-bankruptcy relations. Design/methodology/approach – Inside-debt-bankruptcy relation is tested on three prominent bankruptcy prediction models using correlation and logit regression analysis. Sample consists of 314 Estonian small firms. Financial reports of 2007 are modelled against bankruptcies declared in 2009. Findings – Results imply that users of inside-debt are less profitable; they have weaker liquidity position and less retained earnings. Leverage is not found to be significant determinant between inside-debt users and non-users. Fundamental finding of the study suggests that the use of inside-debt is significantly and positively related to bankruptcy probability. While inside-debt carries no risk elements per se , findings are robust to indicate that the use of inside-debt has significant power to signal for increasing bankruptcy risk and as such, reducing information asymmetry of small firms. Research limitations/implications – This study is limited to single country data. Bankruptcy data fall to the period of economical recession. It is suggested to repeat the study in a normal economical situation and to extend sample size over different countries. Practical implications – Findings contribute to the understanding of firms' financial risk, firm behaviour and capital structure development. In a lending industry, results shall supplement to prudent credit risk assessment techniques and design of bankruptcy models in general. Originality/value – To the author's best knowledge, inside-debt-bankruptcy relation is not studied so far in the existing academic literature.