Financial Leverage and Firm Investment
The relationship between financial leverage and firm investment is complex. This study investigates the impact of financial leverage on firm investment and growth, as well as its relation with the amount of debt held by firms. The researchers found that the relationship between financial and physical debt and the growth of firms is negative. This finding holds true for both high and low-growth firms, and may be particularly relevant in developing countries. While these results are preliminary, they show that the relationship is important when considering the financing needs of firms.
In the empirical analysis, over 40 percent of firm investment is accounted for by external financing. Of this, 19 percent is provided by commercial banks and three percent by development banks. Another seven percent comes from suppliers, while three percent comes from leasing. Less than two percent of firm investment comes from informal sources. Despite the high share of external financing, the relationship is still very significant. In addition, the ratio of current investment to capital is positively correlated with the previous investment to capital ratio, indicating that higher investments lead to higher investments in the future.
Although public finance for small firms is a convenient political sell, the data suggest that they do not finance significantly more investment than their larger counterparts. In addition, programs that focus on expanding the availability of small-firm finance do not address the real problem. In developing countries, a large proportion of such financing goes to larger firms, while small-scale firms do not. In addition, smaller firms cannot compensate for an underdeveloped legal and financial system without alternative sources of finance.
Although government funding is a viable alternative, small firms are unlikely to benefit significantly from this source. The reliance on trade credit does not provide adequate financial incentives for firms, which means that the lack of trade credit may result in a poorer investment climate. The most effective small-firm finance programs are focused on developing countries and the needs of small-scale firms. The broader economic and political context of such programs is often a good political sell.
In the overall sample, public financing for small firms is not significantly more than for larger firms. However, public funding for small firms is not sufficient to compensate for an underdeveloped legal and financial system. Moreover, the use of trade credit is a more lucrative option for small-scale businesses, as it has more opportunities to attract capital. While government funding is often an attractive option, it is not a sufficient alternative for small-scale companies. Instead, it should be complemented with other sources of funding.
As previously stated, external financing is a critical component of firm investment. In a country with a weaker legal and financial system, smaller firms are less likely to use this source of finance. In contrast, firms in countries with a more developed financial system tend to receive more government funds, which helps them to grow. In these countries, government funding is not the only way to finance small-scale firms. The most successful small-scale enterprises can leverage trade credit as an additional source of funding.