The Differential Impact of Leverage on the Default Risk of Small and Large Firms

83 Pages Posted: 17 Aug 2018 Last revised: 4 Nov 2019

See all articles by Lara Cathcart

Lara Cathcart

Imperial College Business School

Alfonso Dufour

ICMA Centre, Henley Business School, University of Reading

Ludovico Rossi

University of Reading - ICMA Centre

Simone Varotto

ICMA Centre - Henley Business School, University of Reading

Date Written: October 31, 2019

Abstract

We analyse a sample of 6 million firm-year observations of large corporations and small and medium sized enterprises (SMEs) spanning 6 European countries from 2005 to 2015, to determine the impact of leverage and different sources of funding on default risk. We find that financial leverage has a greater impact on the probability of default of SMEs than of large corporations. The difference in default probability between the top and bottom leverage quartiles is 1.24% for large firms and 2.87% for SMEs. This difference may be explained by the greater exposure of SMEs to short-term debt and their consequently higher refinancing risk. Indeed, we find that SMEs that recover from the state of insolvency may have similar leverage to defaulted SMEs; however their liability structure is significantly altered towards long-term debt and away from short-term debt. Our findings have important implications not only for bank regulators and policy-makers but also for credit risk modelling.

Suggested Citation

Cathcart, Lara and Dufour, Alfonso and Rossi, Ludovico and Varotto, Simone, The Differential Impact of Leverage on the Default Risk of Small and Large Firms (October 31, 2019). Available at SSRN: https://ssrn.com/abstract=3226246 or http://dx.doi.org/10.2139/ssrn.3226246

Lara Cathcart

Imperial College Business School ( email )

South Kensington Campus
Exhibition Road
London SW7 2AZ, SW7 2AZ
United Kingdom
+44 (0) 20 7594 9126 (Phone)
+44 (0) 20 7594 9189 (Fax)

Alfonso Dufour

ICMA Centre, Henley Business School, University of Reading ( email )

Whiteknights Park
P.O. Box 242
Reading RG6 6BA
United Kingdom

Ludovico Rossi

University of Reading - ICMA Centre ( email )

Whiteknights Park
P.O. Box 242
Reading RG6 6BA
United Kingdom

Simone Varotto (Contact Author)

ICMA Centre - Henley Business School, University of Reading ( email )

Whiteknights Park
P.O. Box 242
Reading RG6 6BA
United Kingdom

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