2-Age and size

2)- Role of age and size in capital structure

There are factors of age and size that influence the pattern of debt financing. Of all small businesses that have started in the United States in the past half century, 50% fail within a year, 25% more within two years, and the rate of bankruptcy declines thereafter. Lenders know that. New businesses have a very difficult time in obtaining loans from banks. Size also influences capital structure because there is an economy of scale in issuing larger loans: the financial analysis of a ten million dollar loan is the same as the one for one million dollar loan. A loan will be larger and cheaper for a large business. Thus, a large business will have an easier time to borrow and a lower rate. Is this reflected in the balance sheet of different size firms? Empirical evidence does not confirm that with certainty. Table T-11.15 below shows means of Equity to Total Assets ratios of approximately 80,000 firms grouped in eight industrial sectors (excluding agricultural and financial sectors), and six size groups (based on data obtained from RMA Annual Statement Studies for 1999).

Table T-11.15
Proportion of equity by company size in eight US sectors in 1999
Size of sales (millions)	0-1	1-3	3-5	5-10	10-25	>25	Ave. all	Ave. >1
Construction	26	40	39	40	40	36	37	39
Manufacturing	13	35	39	40	41	42	35	39
Wholesale	25	33	37	37	35	34	34	35
Retail	25	33	36	35	36	36	34	35
Transportation	22	28	36	37	36	34	32	34
Utilities	39	15	37	39	34	37	34	32
Information	11	17	31	37	29	33	26	29
Services	6	27	37	38	38	33	30	35
Source: Robert Morris Associates, "Annual Statement Studies 1999-2000"

If larger firms use more debt than small firms their equity to total assets is smaller. Except for the construction sector, no decreasing pattern of equity is observable. In fact in most industries the reverse is more likely.

To make it easier to see if a pattern is present in Table T-11.15, the ratios of equity to total assets are plotted according to size for seven sectors in Graph G-11.8.

Graph 11.8

It is clear that the smallest firm have much less capital than larger firms. The reason for that may not be a deliberate strategy. One explanation is that firms that have less than one million dollar in sales are likely to be in sole proprietorships, and placing much funds as equity for such firms is not useful because all loans are backed by the personal assets of the owner anyway, not just assets placed in the business. The second explanation is that many small businesses are in difficulty; or putting another way, firms that are in difficulty become small. This can be deduced from the number of firms with negative net worth among small firms. For instance, in manufacturing sectors, out of 32 industries with firms with sales of less than one million dollars, for which statistics are reported in 1999, nine have average negative net worth; by comparison, only one industry has an average negative net worth for firms with sales from one to three millions, and no industry has a negative net worth for larger size firms. Thus, for very small firms, reliance on debt is not by choice.

Excluding the very small firms, leaves not discernible pattern, with the previously noted exceptions of information and manufacturing sectors. For manufacturing, the trend of reliance on equity is increasing with size of sales, not decreasing. One can interpret this as an indication that the larger firms have greater power to build up the equity necessary to protect them from economic downturns which are especially harmful to firms in this sector.

See review questions Q-11F2.1 through Q-11F2.3.

Previous: 1-Justification
Last modified: Jun/01/01 Next: 3-Leveraged industries