Forecasting Bankruptcy for SMEs Using Hazard Function: To What Extent Does Size Matter?

Abstract

A huge diversity exists within the broad category of SMEs. They differ widely in their capital structure, firm size, access to external finance, management style, numbers of employees etc. We contribute to the literature by acknowledging this diversity while modeling credit risk for them, using a relatively large UK database, covering the analysis period between 2000 and 2009. Our analysis partially employs the definitions provided by the European Union to distinguish between micro, small, and medium firms. We use both financial and non-financial information to predict firm’s failure hazard. We estimate separate hazard models for each sub-category, and compare their performance with a SMEs hazard model including all the three sub-categories. We test our hypotheses using discrete-time duration-dependent hazard rate modelling techniques, which controls for both macro-economic conditions and survival time. Our test results strongly highlight differences in the credit risk attributes of micro firms and SMEs. Simultaneously, the results does not show significant marginal improvements in the classification performance of our hazard models for small and medium firms, over the model developed for SMEs as a whole, while suggesting that there is no need to consider small and medium firms’ category separately while modelling credit risk for them.