Leverage and firm performance of small businesses: evidence from Japan

Highly leveraged small businesses cannot obtain enough credit because of the debt overhang problem. Therefore, highly leveraged firms may lose potential profits from profitable investment opportunities in which they are unable to invest. On the other hand, highly leveraged small businesses can enhance their performance because banks and trade creditors monitor their activity and prevent inefficient management. Using small-business data for Japan, we empirically investigate the relationship between firm performance and leverage. We find, first, that highly leveraged small businesses increase their trade payables less even if they have investment opportunities. Second, highly leveraged small businesses convert more bills receivables into cash by selling them to finance companies to finance their growth opportunities. Third, highly leveraged firms enjoy stronger performance (measured as firm sales growth or profitability) compared with low-leveraged firms. These results highlight the benefits of high leverage for small businesses.