Forecasting bankruptcy for SMEs using hazard function: To what extent does size matter?

Abstract

A huge diversity exists within the broad category of small and medium size enterprises (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 definition provided by the European Union to distinguish between ‘micro’, ‘small’, and ‘medium’ sized firms. We use both financial and non-financial information to predict firm’s failure hazard. We estimate separate hazard models for each sub-category of SMEs, 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 the differences in the credit risk attributes of ‘micro’ firms and SMEs, while it does not support the need to consider ‘small’ and ‘medium’ firms’ category separately while modelling credit risk for them, as almost the same sets of explanatory variables affect the failure hazard of SMEs, ‘small’ and ‘medium’ firms.