Relevance of Pecking Order Theory in Financing Small Firms: Empirical Evidence in West Bengal

Abstract

Small and Medium Enterprises (SMEs) are valuable organs of economic growth and development, in any nation, despite the sector being exposed to intensified competition since liberalization. Small industry has been confronted with an increasingly competitive environment due to: liberalization of the investment regime, favouring foreign direct investment (FDI); formation of the World Trade Organization (WTO) in 1995, forcing its member-countries (including India) to drastically scale down quantitative and non-quantitative restrictions on imports, and domestic economic reforms. The cumulative impact of all these developments is a remarkable transformation of the economic environment in which small industry operates, implying that the sector has no option but to 'compete or perish'. Firms with genuine growth potential can expand and compete if an efficient and effective provision of finance to them is assured (Binks and Ennew, 1995). Own funds and finance from informal sources, which have been the major sources of finance for the SMEs, often fail to meet up this requirement, whereas procurement of external finance (debt) becomes a challenge for the SMEs, given that information asymmetry is one of their inherent characteristics. Thus finance tends to be one of the major obstacles in the way of progress for the small enterprises especially in the developing countries.

Academic literature and observations of business practices indicate that the typical financing pattern of the small business follows a hierarchy with sources requiring information disclosure placed lower in the order of preference. The entrepreneurs in order to avoid the adversities of information asymmetry prefer internal financing as it requires minimum or no information about the firm or the entrepreneur, followed by the short term debt (being less affected by information asymmetry) and finally long term debt (being most effected by information asymmetry). A typical Pecking Order Theory of capital structure explains the financing pattern of small businesses.

This paper endeavors an analysis of the relevance of different financing theories for explaining capital structure choice in the Small Enterprises. An empirical analysis of 100 non - financial Small Enterprises of West Bengal has been undertaken. Our results show that the financing decision in these enterprises could be explained by the pecking order theory of capital structure.