Why Small Businesses Deserve More Credit

According to Wall Street doctrine, small businesses have difficulty raising capital at reasonable rates and are often denied lines of credit and loans because banks believe their risk profile is too high.

“If you really want to stimulate investment, targeting companies that appear to have financial room to maneuver could lead to substantial growth.”

But new research suggests that small businesses are much more financially conservative than banks think. In fact, companies with up to 10 employees are limiting spending on their revolving credit lines to create breathing room, even as banks increase the limit and extend longer-term loans. What’s more, holding on to that breathing room means these businesses may not be growing as quickly as they could, says Olivia Kim, an assistant professor at Harvard Business School.

“If you really want to drive investment, targeting companies that appear to have financial room to maneuver could lead to substantial growth because they appear to have forgone opportunities,” Kim says.

Whether it’s a tech startup or a pet store, small businesses are a major economic force, contributing 44% of gross domestic product in the United States alone. When banks increase their credit, small businesses have room to grow, while maintaining flexibility in their total borrowing capacity.

“I knew that small businesses had to be careful about how they financed,” Kim says. “I was surprised by how much of this financing was being used. The level of utilization was significantly lower than I had anticipated.”

Kim conducted the study with Deniz Aydin, an assistant professor at the Olin Business School at Washington University in St. Louis.

Test case in Türkiye

To test how small businesses manage and use their debt, Aydin and Kim turned to extensive loan data from a large European bank based in Turkey in 2014. They selected a period when the economy was growing and stable after the global financial crisis at the turn of the decade, with conditions that mirrored the current landscape for American small businesses, Kim notes.

The researchers analyzed data from 3,169 small businesses that had been pre-approved for debt capacity increases. A group of 2,414 of them were randomly offered surprise extensions, while 755 other businesses were not offered surprise extensions, serving as a control group.

Firms that were offered increases were informed by phone or SMS. These increases had no impact on borrowing costs, due to Turkey’s interest rate cap, which applied to all firms in this study.

Small businesses take on debt cautiously and strategically

Over time, researchers found that small businesses not only maintained some flexibility but also used more of their debt capacity to pay for long-term expenses beyond day-to-day operating expenses, such as equipment upgrades. Businesses, accustomed to the financial security of being able to roll over their debt into a line of credit, gradually shifted to term borrowing.

The researchers discovered:

• Less than 10% of firms were “actually financially constrained” with ratios above 98% for total credit utilization. Instead, average credit utilization was 39% before credit extension was offered.
• Businesses increased their borrowing by 61% after increasing their credit over 12 months compared to the previous year. That’s 35 cents for every dollar they increased their debt capacity.
• On average, companies have shifted their reliance on two-year borrowing to begin investing for the longer term, primarily through term debt.
• The increase in debt capacity has led to growth in companies, with profits increasing by 35% per year. Growth is even stronger for companies that are further from the debt limits.
• Default or debt restructuring rates have not increased with increasing borrowing capacity.

“It’s amazing because companies aren’t even using all of their credit lines,” Kim says. “They’re only using 55 cents on the dollar. So just having the ability to borrow more can drive growth.”

Lessons for small businesses around the world

Looking for potential reasons, one might conclude that the companies that didn’t ask for a raise were in “an environment where access to credit is very difficult, and the companies may not be very sophisticated either,” Kim says, adding that they may be learning how to use credit lines for the first time. “But if you actually look at the data, there’s no variation in how they respond based on their prior experience.”

“We can achieve economic growth by targeting these companies.”

Given Turkey’s economic stability at the time of the experiment, banks and small businesses in the United States and elsewhere should take note of the results. In fact, the type of private and bank-dependent firms studied mirrors the composition of 80 percent of U.S. firms and 90 percent of global firms.

“The main implication is that the precautionary motive of preserving the buffer was previously holding back sales,” Kim says. “Policymakers can take this into account. Economic growth can be achieved by targeting these companies.”

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